5 Common Trading Mistakes And How To Avoid Them

AdminBy AdminOct 28, 20170

If you’re new to trading the financial markets then you almost certainly have a steep learning curve ahead. While some lessons can only be learned through experience and may be very specific to your own personal circumstances, goals, psychological makeup and attitude towards risk, there are also a number of trading mistakes that are extremely common yet easily avoided.

As we take a look at the five most common trading mistakes in the article below, we’ll also explore some simple, actionable steps that you can take to avoid these pitfalls and make your own trading journey as smooth as possible.

Mistake 1: Using Excessive Leverage

Mistake 1: Using Excessive Leverage

Leverage is simply the use of borrowed funds to control an asset. For example, mortgages and home loans are a form of leverage where only a small proportion of the overall purchase price is put down by the buyer in the form of a deposit, and the remainder is borrowed and interest paid on the loan.

In the financial markets leverage is commonplace for certain classes of financial instrument, including futures, contracts for difference, and forex. It is also possible to trade stocks with leverage, although most brokers place significant restrictions on this.

Leverage is expressed as a ratio, so leverage of 10:1 means that for every one dollar that the trader deposits in their account they are able to borrow a further nine. Depending on the jurisdiction in which you live, you may be able to access leverage as high as 500:1, so that with an account balance of just $2,000 you would be able to purchase assets worth $1 million.

The key feature of leverage is that it is a “double-edged sword”, and it amplifies losses in exactly the same way as it does gains. Seeking to make the most of their edge in the market, many new traders employ excessive leverage, and then a short losing streak can be enough to wipe out the balance of their accounts.

Avoiding Too Much Leverage

You don’t have to use leverage just because it is offered. For beginners it is advisable to ignore leverage until you have built confidence in your approach and confirmed you ability to make consistent profits; after this leverage can be introduced at a gradual rate. As a guideline figure, it is worth keeping in mind that regulators in the US restrict the amount of leverage that can be offered by brokers to a maximum of 50:1.

Mistake 2: Misunderstanding The Impact Of Fixed Costs

Mistake 2: Misunderstanding The Impact Of Fixed Costs

While there’s nothing wrong with day trading (holding positions for no longer than a single daily trading session) per se, problems tend to arise when day traders target frequent, small profits without a mathematical understanding of the impact of fixed costs.

For example, consider a strategy that averages profits of $50 and losses of $50 in the S&P futures. The market trades with a spread equal to $12.5, has an average slippage per trade of $5, and generates commissions of $5 per trade. The total fixed cost per trade will therefore be $35. What percentage of trades must be winners in order for this strategy to be profitable?

The answer is that a win rate of more than 85% is required to realise a net profit. Unless you have a very high confidence in the strategy to generate upwards of 85% winning trades it would be unwise to trade it.

Overcoming Fixed Costs

The easiest way to conquer this problem is to trade strategies where there is an expectation of a larger average trade profit. These costs (spreads, slippage, and commissions) are relatively fixed, and will remain the same for a strategy with much larger average trades, meaning that costs have a less significant impact on your net profits.

If you must day trade, explore strategies that use limit orders to enter and exit positions wherever possible. These passive order types are widely used by market makers and mean that the spread cost element is eliminated.

Mistake 3: Failling To Test Strategies Throughly

Mistake 3: Failling To Test Strategies Throughly

There are no absolute certainties in trading, and all those who participate in financial markets must be comfortable with this fact, and prepared to evolve with changing conditions.

However, those who merely assume that their strategy will work on the basis of a small handful of examples, anecdotal evidence, or blind optimism, are usually destined for disappointment. None of us knows for certain what will happen in the future, but at least we can be certain of how our strategy would have performed in the past.

How To Test Your Ideas

To carry out research and see how your trading idea would have performed, a process known as “backtesting”, you can use a wide variety of different software products, or possibly the charting platform and historical price data provided by your broker. Many backtesting solutions now remove the need for any complicated programming, as well as offering detailed reports and analysis of your strategy’s historical performance.

When you’re engaged in backtesting, avoid the temptation to “over-optimise” your strategies. This means endlessly tweaking parameters until a perfect outcome is achieved for past data. Future price behaviour is unlikely to be perfectly identical to what was found in the past, and your strategy won’t prove robust or effective in real trading.

Mistake 4: Poor Diversification

Mistake 4: Poor Diversification

Diversification is often referred to as “the only free lunch in finance”. It costs almost nothing to diversify your investments across a range of uncorrelated markets, and yet many traders make the mistake of investing in closely related securities that move in tandem and yield concentrated risks.

Achieving Diversification

To achieve better diversification, seek to trade a portfolio of around ten markets. Quantitative research has shown that this is usually an optimal number beyond which the benefits of diversification cease to be proportional, so don’t expect a twenty market portfolio to halve your risk when compared to a ten market portfolio.

The key concept here is that the group of markets traded must not be correlated. This independent price behaviour allows for returns in one market to offset losses in another, minimising volatility and smoothing the equity curve.

Many active traders cite a need for “specialisation” as the reason for their focus on just one particular market or stock. Even within a single market, however, it is possible to reap the benefits of diversification by employing multiple unique strategies alongside one another.

Mistake 5: Over-Trading

Mistake 5: Over-Trading

Over-trading is a particularly common problem among day traders, although it can affect longer term swing and position traders as well. The issues arise not from the frequency of trading itself, but from the fact that involvement with the market becomes compulsive, leading traders to take low probability positions that don’t meet any specific criteria.

Combating The Temptation To Over-Trade

To avoid this problem the best approach is to have a clearly outlined strategy that specifies the particular circumstances that will induce trading, and then to develop the personal discipline to adhere to this system without deviation.

This doesn’t mean that you must trade mechanically using a computerized algorithm. You can execute trades manually and work from a simple set of entry, exit, and position sizing rules written down on a piece of paper. The important point is that you only take action when these criteria are met.

Conclusion

If you are able to avoid the five common trading mistakes that we’ve outlined above, not only should you start out ahead of most other traders and retain more of your capital, but you’ll also be able to focus on identifying learning objectives that are more unique to your own circumstances and trading strategies.

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