Trading mistakes to avoid

Whilst picking the right product is important, it is capital preservation that is the most valuable consideration when trading. Too much focus on the upside with little regard for an exit strategy on the downside makes it difficult to know when to exit a position to preserve your capital. It is unwise to buy and hold, regardless of the product’s performance, some changes in trend can last years which could tie up large amounts of your trading funds.

Stop losses are a vital part of an effective risk management strategy. One of the simplest ways to help with stop loss and take profit order placement is by using support and resistance.

Stop loss and take profit order placement

The line chart above shows an upward sloping trend. Using the support as an entry point, a buy position is entered on this product when the price bounces off this line for the 3rd time with the assumption that the price will continue to rise.

Before the trade is placed, a stop loss level should be identified. A popular method to use is to look to a previous significant low in the price, also called a support level. Stop losses set just under support areas are commonly used as, if the price breaks further below, also called a technical breakout, then a short term spike down in price can be expected. It is unwise to run a losing position further after this point.

This level is at $3.50, slightly below the support, which is now the lowest price the product can fall to before the stop loss is triggered. This is a maximum loss of 25 cents per share.

The next step is to identify a level at which to set a take profit order. This is usually just under a significant resistance level - the thinking here is that, when the price reaches this previous significant high (around $4.50), market participants might look to take some profit and the price could fall. History tends to repeat itself so the favoured outcome is that this pattern will continue.

Another example for stop loss and take profit placement

In this example there has been a sideways trend that has just broken out of its range, providing a technical breakout (usually a short term spike up can be expected). A buy position is usually entered just above this price, so it is more likely that a change in trend is underway and not a false breakout (when the price reverses again). A significant break above the resistance is usually considered enough confirmation.

When identifying suitable stop loss levels it’s best to look for areas below the current price where you can see evidence of previous buying. The first support level is at $4.25, which would result in risking only 50cents per unit.

If the closest support is regarded as being too close, then another option is to place the stop loss at the second support level, at $3.75, but then there would be a risk of $1.00 per unit.

There is always the option to lower the position size (number of units) to cater for a wider stop loss position. In this way it is possible to risk the same amount on both trades, even though the stop loss isn’t in the same place.

The trade off: Bigger stop loss, less profit on the upside, if the market risk is the same.

With regards to the take profit order, a previous high (or resistance) is not the only form of guidance, a strategy such as risk vs. reward can be useful. A three-to-one risk-to-reward would mean stop loss 1 would be a risk of 50 cents to make a reward of $1.50. This strategy can be worthwhile if the next technical level is some distance away (or if the product is making fresh all-time highs or lows).

Position sizing

There are a number of different position-sizing models available, and most determine risk, based on either a fixed dollar amount or a fixed percentage.

A popular method for short term investors is to risk only 2% of their trading capital on any one position. Not only does this mean the risk is a very small amount per position, relative to their trading size, but it allows placement of 5 or 6 trades without having to risk more than 10 – 15% of the trading capital at any one time. If investing over longer time periods with a wider stop loss, it is common to adjust the trading capital at risk per position to a higher percentage.

It’s sensible to consider overnight interest costs too, if applicable, as these can begin to add up, especially if a lot of financing is used on the position.

It is a common mistake to place too much capital on any one trade. In order to combat this and to have a purely mechanical way of calculating the position size (number of units), the following formula can be used:

Position Size (number of units) is equal to Maximum Loss divided by the selected Stop Loss Size.

For example, when considering a short-term investment, using a trading account of $10,000 and a maximum risk of 2%, the maximum risk or loss for this investment would be $200.

To determine a stop loss, the identification of a suitable support level is necessary. On the basis of this chart, a buy position is entered if the price breaks the resistance line at $1.56, resulting in a technical breakout. The stop loss would then be placed just below the previous low (or support) at $1.36, thus there would be 20 cent stop loss on this trade.

$200 (2% of $10,000) divided by 20 cents equals 1000. This is the number of units (position size) to take out on this position if trading on a 2% maximum risk.

Types of stop loss tactics

There are two types of stop losses, the standard fixed stop and the trailing stop.

The fixed stop loss is set at a specific price which is chosen by the trader and it will remain there until they exit the position or cancel or amend it. Standard stop losses are most commonly deployed when investors first enter into a position.

A trailing stop is set a specific number of points away from the current product price and will automatically trail that set number of points behind the position if it moves in the chosen direction. Trailing stops can be useful if investors want to run a position for as long as possible without a specific profit target. The trailing stop acts as risk management and as the mechanism to eventually close out the position, hopefully at a profit.

Investors typically use a standard stop at the start of their positions and if they start to show a healthy profit then a switch to a trailing stop can be beneficial, rather than closing out and exiting early.

The second big mistake to avoid involves investing without having a cohesive strategy. Building a cohesive strategy that encompasses all elements of investing is important in order to build consistency and confidence in each position. It is useful to have a set of rules to follow. A basic trading strategy may include the answers to these components:

When is a good time to buy? A strategy around either fundamental (news flow) analysis or technical analysis will give clear signals as to when to buy or sell.

How much should be bought? By using stop losses and calculating the maximum risk willing to be accepted, you can establish how much to buy.

Is it time to sell? By using a mixture of technical analysis and any recent fundamental news, it’s possible to make a decision on when to sell.

Should more be bought? A good strategy is to consider adding to positions if there are signals to do so. However, doubling up can quickly wipe out profits, if the market moves in the opposite direction.

What timeframe should be looked at? This will come down to how much time can be dedicated to investing, and if this is a day trade (where technical analysis is used) or a longer term investment (with greater research).

What products should be traded? It’s advisable for investors to stick to products that they are knowledgeable in i.e. they should know how certain products operate and react to news releases and technical signals. Studying a product more closely gives added confidence in the investment. It is unwise to trade products that are unfamiliar.

Should you trade long or short? Don’t be afraid to short sell because you’ve never done it.

A clear methodology is required when selecting positions in order to accurately identify and select good trades over bad ones. Without consistent methodology it is difficult to distinguish the real trading successes from ones that have happened simply by chance.

To develop a suitable method it helps to start a trading diary. It’s possible to save time, money and stress by creating a blueprint of all the possible strategies that one might use when trading. It’s beneficial to keep track of all the reasons one may have entered into a particular position, and then the outcome. It helps one stop the repetition of old mistakes and to learn the most effective methods.

A good gauge of consistency is that there won’t be a need to wonder if a setup should be taken or not… simply following a specific method and set of rules will show the way.

Trading diaries and good record keeping are the best ways to fine tune successful methods.

Questions

A reliable investment approach should satisfy the previous conditions above for the sake of safety, and it should also suit the individual. Here are a few questions to ask yourself that will help you establish your individual needs:

Short term or long term? A lot of people think that the most profitable traders are those that trade in the short term, but that’s not necessarily the case. Medium to longer term signals are quite often more reliable than the volatility of short term moves.

Do I have access all the time? When trading in the very short term you would need to access your positions at all times. This isn’t appropriate to most.

Do I have time for analysis? Detailed fundamental analysis can be quite time consuming. There is also a need to analyse future positions and manage those that have already been opened. For people who work full time, a method that requires constant monitoring of charts will not be appropriate.

Am I properly educated in my method? For those looking to use technical analysis for the basis of their investments, correct interpretation of the signals is vital. If the trader is looking more closely at fundamentals and news flows surrounding a product, they should have a good idea of how the information influences the price of the product.

Trackers allow extraordinary flexibility because of the use of customisable financing, which can allow you to invest in positions without having to pay the full value of the position up front.

For example, investing in the likes of indices or foreign exchange can offer a maximum financing rate of 99% (the trader just has to outlay 1% of the total position) meaning a $100 deposit can give access to $10,000 worth of the underlying product. Although this gives greater access to the markets, it also increases the risks if markets move against the trader. With Trackers it is possible to choose the exact amount of financing, if any, that is required to meet your specific investment objectives, but remember, the more financing that is used the greater the overnight financing costs will be.

For those new to Trackers, it can be worth considering placing a threshold on the maximum financing that is applied to the total capital. In order to remain relatively conservative, a limit of 3x leverage may be appropriate.

This would mean with $10,000 in an account there wouldn’t be a need to take on more than $30,000 worth of market exposure (total value of the positions).

Stop losses are very important but if there is a sudden fall in the market, a conservative amount of market exposure can be of even greater importance.

The benefits of placing stop losses near previous significant price levels were covered earlier. These support areas can limit losses in price, though, if the market exposure is large, the loss can still be quite significant. For example, a stop loss at 25 cents equates to a loss of $2,500 when the exposure is $10,000. If the exposure was $5,000 the stop loss of 25 cents would lead to only a $1,250 loss.

Many investors can become fixated with finding their next position – this is dangerous if it is at the expense of monitoring existing positions. A daily review of the charts of each position is useful to ensure confidence in these trades and their on-going suitability. It’s advisable to keep clear records on each position, including the profit or loss, days held, overnight costs, win/loss ratio, average profit size, average loss size etc. The more detail that is available on each position the easier it is to spot problems with investing techniques. Keeping a trading diary is very worthwhile as it helps you keep track of the reasons for each investment as well as your thoughts on the performance. You can then refer back to these notes when reinvesting in the same products in the future.