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Written and copyright © 2009-2013 by Thomas N. Bulkowski. All rights reserved.
What are the three most common and important mistakes that traders make? I have no idea because I didn't conduct a survey, but I do know three important
mistakes that if you can avoid making them, you will become a stronger and more profitable trader. This article discusses those three mistakes and tells you how to avoid them.
Mistake #1: Not using stops.
You know this had to come first, and it is probably the most important. It may surprise you to learn that if you do not use stops, you can
make more money than if you do use them. I have proven this in my system testing for the test portfolios on the website, and it is common knowledge.
During development, whenever I included a stop, performance deteriorated. That’s also
why those two portfolios do not use stops, and that is also why they are showing gains this year (as of September 2008) when the market is down almost 20% since January.
Stops tend to force you out of trades that will later become your big winners had you held onto them. Stops placed at common locations such as round numbers (10, 20, 30 or even
the decimals, 0.50, 0.60, 0.70), minor highs and minor lows, become targets for experienced traders. They know that if they can force price to take out the stops, they can sometimes
cause stop running or gunning the stops. That's when the trigger of one stop causes price to drop which triggers another stop and then another and down the stock goes. It rarely
happens, I think, and it is difficult to prove anyway, but that is the theory.
Having said that, let me also say that I do not use stops on my long term holdings. I am willing to let them fluctuate further because I intend to hold them for years. They are the stocks
in which I expect to double or triple my money or collect juicy dividends while waiting for them to appreciate. But in my shorter-term trades, you can be sure that I use stops.
It sounds like a contradiction, but it’s not. If a long term holding drops too far and I fear for survival of the company (or other factors), then I will sell it.
But for shorter-term trades, every
trade has a target price and a stop price. That way, I can limit losses when the market goes against me. Even for long term holdings, you can say that
I use a stop, it’s just that the stop is a very wide one and it’s held in my head, but also documented on paper.
Stop Fix
I became consistently profitable when I started using stops in my trading. It allowed me to limit losses, but also to capture gains. I use a trailing stop, raising it as price rises.
That way, even if price returns to the purchase price, I will have made money because I was stopped out at a higher price.
If making money is important to you, then use a stop on every trade. The worst thing you can do is not use a stop and see a large gain turn into a loss or watch a loss grow from 5%
to 20% then 30% or more.
All large losses begin from small ones, so use a stop on every trade. For longer-term holdings, such as core positions, have a price at which the market is saying you
made a mistake. And when price reaches that exit price, get out.
That is what the pros do. If you consider yourself a professional trader, or a pro trader in training, then use a stop. Amateurs don't, and they lose money.
Mistake #2: Ignoring sell signals.
Imagine that you are in a trade and get a sell signal. Do you sell? You believe that price will continue rising, so you decide to ignore the signal and hold on. Guess what? You're right!
Price moves higher, just as you expected and you sell later for a larger profit.
Congratulations! You have just taught yourself that when you get a sell signal, you can do better by ignoring it. That
is how bad trading habits form, and it is a classic mistake.
Unless you have a poor trading system, ignoring a sell signal will eventually catch up to you, and you will take a huge loss. It is only a question of time. If you use leverage,
perhaps the loss will be large enough to wipe you out. Do you really want to lose everything you own simply because you chose to ignore a sell signal?
Sell Signal Fix
Take the time to understand your trading system. Test it until you are comfortable obeying the signals that it gives. When a signal arrives, act on it.
If it helps, pretend you are telling your mother how to trade the stock. Would you tell her to ignore the signal or obey it? How would a professional trader handle the signal?
Mistake #3: Learn from mistakes.
If you don’t learn from your mistakes, you are doomed to make them again (so the saying goes). Even if you do learn from your mistakes, you
will probably make them again anyway. That is the nature of emotional trading. We are not perfect. After over 30 years of trading and investing in the stock market,
I continue to make variations of the same mistakes.
Periodically, usually after year end, I review my trades. I look at what went right and what failed. I look for common threads among the trades that highlight bad habits forming.
I will use the trading spreadsheet to determine whether I am early or late getting into and out of trades. I search for patterns that work especially well
and hunt for techniques that failed. I ask myself, "If I followed my rules, would I have made more money or less?" "If I limited losses to x%, would I have made more money or
would I have limited my big winners?" Testing is required to find the answer, but that becomes part of the review process.
Often when I undertake a review, not only do I learn from it, but I get new ideas. Those ideas may lead to more profits or smaller losses. That is how I learn to improve my
trading style.
Learning Fix
You cannot learn from your mistakes if you don’t know what you’re doing wrong. Reviewing your trades can help you identify the problem areas. This is especially true
if the markets change. That will happen as markets switch from trending to trading range, bull to bear or bear to bull, volatility increases or decreases and any other
factor that makes investing or trading a challenge.
If you review your trades, make note of what is working and what is falling behind. Change your trading style to the current market conditions and what you expect in the future.
For example, when I started losing money as the markets dropped in 2008, I cut my position size to one-fourth of what it was and then to one-eight. Even though the losses continued,
they were significantly lower than what they could have been.
So that is the list of three trading mistakes and how to fix them. Use stops on every trade, obey your trading signals, and learn from your mistakes. If you obey these three suggestions,
you will become a better trader.
-- Thomas Bulkowski
Written and copyright © 2009-2013 by Thomas N. Bulkowski. All rights reserved. Fish bowl: A glass-enclosed isolation cell where newly promoted managers are kept for observation.
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