To succeed in the stock market in the long-run, individuals have to avoid making common trading mistakes.
For example, the bursting of the 2000 dot-com bubble has proven to everyone that relying on hype can cost you your entire portfolio.
As seen from the example, stop losses have saved those who use them frequently the potential loss of their money by alm
Overtrading
Overtrading is an error that frequently occurs under volatile market conditions and even among experienced traders.
The primary contributors to overtrading are fear of missing out and the desire to recover losses as rapidly as possible.
For example, a frequent high-volatility event, such as the posting of data or announcements of quarterly earnings, can be easily associated with overtrading.
During such news, a trader might make many trades a day when ordinarily they would not make more than five.
This is the 300% increase in trade that must be considered a sign that a person is overtrading.
Increased trading leads to decreased returns on each trade. For example, in the event of overtrading, while the number of trades a trader makes might increase 300%, there will be no proportional increase in the net’s profitability. It might even decrease.
More trades come with more costs to make trades, and while they might be relatively low in comparison to the potential profit, they still exist.
Indicators such as moving averages of trading activity can give away whether a trader is overtrading. For example, you would want to compare a 10-day simple moving average of the number of trades you make a day to a 30-day simple moving average. If the short moving average is 300% larger than the long one, you are probably overtrading under the condition your profit does not increase accordingly.
Ignoring Stop Losses
Ignoring stop losses is a very frequent mistake, and it may lead to increased risk and higher possible losses. The reason for this error is generally explained by the fact that traders make decisions based on emotions, and many of them would still hope or be afraid that they will be right instead of losing.
This level of the stop loss price is chosen before selling the stock, and when this price is reached, a trader sells to avoid further losses. Accordingly, without setting stop loss, in cases of market fall, a hope that some day a market will raise prevents a trader from selling that results in losing money.
For example, if one buys a stock with the price of $50 and sets stop loss price $45, the loss will be only 10%. If not to do it and a stock price falls to $30, the final loss will be 40%, which is double more than in the case of setting a stop loss.
Data shows that investors who have stop loss orders in more cases successfully pass the crisis because of lower variances of the stop loss portfolio than predictions of portfolios that do not use stop-losses orders . Setting stop losses may be performed in accordance with some technical indicators. For example, traders may apply Average True Range is a technical indicator measuring market volatility.
Poor Risk Management
The one pivotal error that is made more than often and which leads to major financial losses is poor risk management in stock trading. One of the most classic mistake of this sort is not diversifying the portfolio, as it renders trader risk since the poor performance of a single stock or a sector will bring the total value of the portfolio down.
For example, if a trader puts 50% of his capital into a single tech stock, rather than diversifying it investing in varied sectors, one can expect that if tech industry declines, the total value of his portfolio will also shrink significantly. There are statistical measures, like the Sharpe ratio, that can show how much of additional return for the extra volatility that a trader is getting. A well-diversified portfolio should yield a higher Sharpe ratio, meaning a better risk-adjusted return.
Another common error is that trader does not adjust size of position adequately with regards to the volatility of the asset. Instead, traders should make use of volatility index as a guideline and change their position sizes accordingly. If the VIX goes up, position sizesshould be decreased to prevent greater losses. The axiom that the best rish management strategy is knowing what you are doning is perfectly encapsulated in Buffet’s “Risk comes from not knowing what you’re doing” .
Following Hypes Blindly
One of the most common errors among uninformed traders is jumping into stock trades motivated by media hype or speculative frenzy.
This often occurs because people who are not experienced in the field fear to miss out on some supposed quick gains .
For example, during a viral stock tip phenomenon, when a stock could grow by 30% in a single day based on a buzz in the social media, traders frequently pour in without an exit strategy or understanding what the stock is. As a result, they buy at the peak price just before the fall that is guaranteed to happen.
In the current case, the data-driven approach would involve analyzing the historical price actions of similar hype-driven stocks.
Normally, one could see a very steep rise followed by an even steeper fall a day or two later, with the additional or reduced volume of trades that rises and air as the price falls. In this situation, technical indicators can be of additional help, such as RSI and MACD that can show that the stock is overbought and, hence, it is time for the falling action.
For example, in the RSI normally if the RSI rises above 70, it is a strong signal that the stock is overbought and there is a strong risk of a strong sell-off . In this case, Warren Buffet advice seems particularly proper, to be fearful when others are greedy, and greedy when others are fearful . In the current case, those who followed the hype were the greedy party, while the prudent ones who retained from purchasing the expected high value after the peak were the wise ones.
Neglecting Research
Neglecting to do thorough research before making stock trades is a critical error that often leads to irrational and thus risky investment. When traders do not know much about the company, its industry or the market situation in general, one may suggest that they are simply playing the game.
Imagine that you hear about the biotech firm with a great product that has just been released. The day you hear this, the trader has announced that he bought this stock and that everyone should do the same without opening the latest earnings report or at least looking at the company pipeline.
The day after the information was released, your investment might soar because dozens of other traders would hear about the great news and buy this share, expecting it to grow. However, the stock has no reliable financials or a product that is even nearly ready to be released, and it would inevitably go down.
The EMA or the Bollinger Bands would help it pick up, but I could suggest this only if combined with fundamental analysis . For instance, if the share price is constantly above its 20-day EMA, it is likely on a steady upward trend. Still, if traders do not know why the stock soars, could not be sure about it being something long-lasting.
Peter Lynch said that the golden rule is simple, “know what you own, and know why you own it.”
Undercapitalizing
One mistake traders make is undercapitalizing. Starting with insufficient funds will severely restrict a trader’s ability to do the market.
Not only can traders not allow to invest in diversified instruments, but also it would not let to withstand loses that happen. An example would be a trader starting with a $1000 balance and deciding to ladder high-volatility stocks.
Assuming the stock prices can move between 5-10% in a single trading session, if one of the prices goes against the trade, the total available capital for the trader will be affected. The $1000 will decrease to $900 in case where the trade goes against the trader by 10%.
The loss will be equal to $100, which is 10% of the whole trading capital. In such a scenario, position sizing becomes a core decision. Proper risk management means that no more than 2% of one’s capital should be at risk in a single trade. The 2% of $1000 is equal to $20, which is the maximum amount that should be invested in the case of trading a high-volatility instrument.
The nature of high-volatility assets makes it impossible to put more smaller stop loss order, as the current volatility demands much larger stop-loss margins to withstand all the regular price fluctuations. “Do not save what is left after spending, but spend what is left after saving” by Warren Buffett.
Overreliance on Automation
Due to the wide presence and common use of automated trading systems, many traders have overrelied on such technology, deceiving themselves that the system is to replace their wits and knowledge of their markets.
However, this is a rational error that inevitably leads to disastrous mistakes when market conditions differ from the standard in which the automated system was programmed.
For example, let us take a trading algorithm that is programmed to execute certain types of trades when such technical indicators as moving averages or RSI levels are present. If the market becomes highly volatile or behaves abnormally, then the values demanded as a prerequisite for the irruption of the planned trade might not be appropriate.
Specifically, in case of a flash crash, a situation where prices fall and climb back in the course of a few minutes, there will be no time for automated systems to realize the irrationality senseless fall and sell at low price needlessly.
In other words, the role of automated systems in trading should be to accelerate and streamline their actions without overtaking them entirely.
For instance, over-sold signals can be detected and trigger a notification. But it would be a rational unchecked to react to them personally based on the situation, the local piece of news, and the mood of the trader. As Buffett says, “the investor of today does not profit from yesterday’s growth.”
Forgetting Past Lessons
One of the most damaging errors in trading is not learning from past experiences. It allows traders to make the same mistakes again, such as not setting up stop-loss orders or chasing losing trades, leading to further financial demise.
Let us consider an example.
A trader might see that not managing the trade well has led to a great loss because they have no proper risk management tools in place .
Gradually, their trading degenerates, and when the conditions change, they get the same exact losses once more. Trading according to a trend is a much lighter mistake than trading against it, but it can still bring a trader considerable losses .
In the words of John Maynard Keynes, “The difficulty lies not so much in developing new ideas as in escaping from old ones.”
Lacking a Trading Journal
An absence of a trade journal is a severe problem for every trader as it limits the ability to continuously discuss the performance and improve all strategies.
A lot of traders who engage in the buying and selling of stock every day base their decisions on the current trends or their feelings that mostly steer them wrong.
Such speculations are not documented, and as a result, people do the same mistake again and again.
For example, a stock trader may make a decision to enter a position basing on the breakout pattern.
Specifically, a note should contain the date, entry and closing levels, sizing, stop-loss and take-profit levels, and a write-up on why that trade was entered or exited .
Over time, a large dataset will be gathered, and by analyzing some components of a profitable trading plan, one may understand the win rate. That is why I think that a trade station is a helpful tool.
