While beginner traders are more likely to make trading mistakes, even the most experienced traders falter from time to time. But what distinguishes a good trader from a mediocre one is the ability to learn from mistakes and improve. Here are some of the most common trading mistakes and the best ways to avoid repeating them. (For more on rookie mistakes see The Worst Mistakes Beginner Traders Make)
Trading Mistake 1: Excessive leverage
Traders generally take on excessive leverage because they have limited capital of their own to trade with. Leverage is tempting because of its ability to boost positive returns. But on the flip side, it can also magnify negative returns. While accumulating additional capital is not easy, avoid the temptation to take on too much leverage by keeping in mind that borrowed funds have to be repaid. Just because a leverage of 4:1 is available for stock trades and 50:1 for forex trading does not mean you should use it.
Nevertheless, if you are using a high degree of leverage, you would be well advised to develop a game plan for capping your losses and sticking to it. Otherwise you may be digging yourself into a hole from which it will be very difficult to emerge.
For instance, let’s say you have $25,000 in margin and based on leverage of 4:1, have a trading position of $100,000. Even before placing this order, you should have already set a stop-loss as a hard line in the sand. If your let your losses mount, just a 10 percent loss on this trading position would wipe out 40 percent of your margin, restricting your ability to trade until you bring it back to the minimum $25,000 mandated by U.S. financial regulators for day trading. Far better to put in an ironclad stop-loss (of say 1 percent) so that you have at least conserved your initial capital if the trade does not work out.
Trading Mistake 2: Taking highly concentrated positions
Taking highly concentrated positions may work for an experienced and skilled trader, but for most people, it constitutes risky trading behavior that needs to be redressed before it leads to a trading disaster. Some of the biggest trading losses have occurred because a trader was so convinced of the merits of his trading strategy (we use the masculine pronoun here because the perpetrators of the biggest trading losses in history have been almost exclusively male) that he threw caution to the winds and kept adding to a trading position even when it wasn't working out. Spread your bets, rather than wagering everything on a single stock or asset. Compute the maximum loss that could occur if a concentrated trade goes south, and compare this with the loss that may arise from a diversified strategy (for example, long-short or pairs trading). Most traders are much better off choosing a diversified strategy.
Trading Mistake 3: Trading too frequently
Trading too frequently is another pattern of risky behavior to address before getting a lesson from the school of hard knocks. A common reason for overtrading is that the trader feels compelled to put on a few trades after staring at the screens for a couple of hours. Trades entered into without adequate homework or a compelling justification may need to be reversed quickly in order to cap losses. Better to do groundwork on a trade before entering into it. Keep a detailed log of your trades so that you can assess the negative impact of overtrading on your net worth.
As Warren Buffett says in The Tao of Warren Buffett, “You don't have to swing at everything—you can wait for your pitch.” By biding your time for the right trade, you can pick up a lot of singles and doubles and even the occasional home run.
Trading Mistake 4: Not sticking to the game plan
There are endless ways to deviate from the game plan, usually by making little tweaks and adjustments. It could be by changing or removing a stop loss when a trade is in danger of triggering it, averaging down to add to a losing long position or averaging up to add to a losing short position, or staying too long in a profitable trade. The danger here is that abandoning the game plan may lead to mounting losses, or could turn a gain into a loss. Keep in mind that discipline is one of the key traits possessed by successful traders. Work at attaining trading discipline in a conscious manner by following the strategy you have developed and adhering to your defined entry and exit points for trades.
Trading Mistake 5: Skewed risk-reward
Evaluate the risk-reward for a trade before getting in, since it’s best to avoid a trade with a skewed risk-reward. A classic example of such a trade is option writing, where the maximum reward for the option writer is the premium received, but the maximum risk is theoretically unlimited. Even so, there are plenty of traders willing to write options because the odds are on the side of the option writer. Trades with a skewed risk-reward profile are only worth considering if you already have the requisite trading experience, have a suitable risk mitigation strategy, and are not deficient in capital. If you do not possess all these attributes, look for trades with a more balanced risk-reward profile.
Trading Mistake 6: Trying to get even
"Don't get mad, get even,” may be a good tag line for a Hollywood blockbuster, but it is terrible advice for a trader. Inexperienced traders will find it very difficult to reconcile themselves to losses incurred from trading and the temptation more often than not is to "get even" by trying to make the losses back. This situation is fraught with peril, because the trader may make hasty and uninformed trading decisions due to his emotional state. These trades could end up losing even more money. A better course of action would be to stop trading for the day and start afresh the next day.
Trading Mistake 7: Being ignorant or uninformed
Because the financial markets attract the best and the brightest, traders have always had to compete with the best minds in the business, many of whom have the advantage of having very deep pockets and virtually unlimited resources with regard to trading platforms, analytical software, and research capability. So how can a small trader with limited capital and few resources even the odds? Through knowledge and information. If you have the passion, with a little effort, you can develop a trading knowledge base through diligently perusing courses and online material (although when it comes to information flow, you will still be at a disadvantage to institutional traders in the big financial centers). In the words of legendary trader Paul Tudor Jones, "The secret to being successful from a trading perspective is to have an indefatigable and an undying and unquenchable thirst for information and knowledge." So do your homework and your research before initiating a trade, because you can rest assured that millions of other traders are.
The Bottom Line
Just as to err is to be human, trading mistakes are unavoidable. Successful traders learn from their mistakes so that they can avoid making them again in future.