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The 7 Deadly Sins of Trading.
Never Do These If You Want to Succeed in Trading.
Trading is a numbers game and while we try to make every bit of effort to find a profitable strategy, we still fall into some common and uncommon traps that prevent us from achieving our goals. Below are 7 things that can ruin our whole trading framework.
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7. Falling Into Emotional and Cognitive Traps.
There are emotional and cognitive biases that can hurt our results pretty badly. Here are a few selected ones:
Conservatism is when a trader is slow to react to new information and places too much weight on base rates. The way to deal with this bias to force one’s self to be skeptical of her basic analysis and to be always dynamic and ready for change. The market does not look too far into the past.
Confirmation bias is when the trader focuses on positive information and dismisses negative information. This is by far one of the most common ones and it is actually a normal state of mind that leads to overconfidence. By positive information, I mean the ones that seem to support the trader’s initial view. So, if the trader is bullish, she will only look at positive news on the security and disregard any bad news on the company.
Hindsight bias makes the inflicted overestimate her past accuracy and can lead to excessive risk taking. The majority of predictions are made with hindsight. This means that we can all look at past charts and conclude that the future direction was to predict. Most back-tests also suffer from what is known as look-ahead bias which is the hindsight equivalent of a systematic machine strategy. It is simply defined as the fact of including data that happened after the prediction point making it unrealistic.
Availability bias is about selecting investments based on how easily their memories are retrieved.
Loss aversion is by far the most common emotional bias that exists and it is the act of cutting gains too soon and losses too late out of fear of missing out. The best way to remedy this is to stick to a fixed risk-reward ratio and to automate the position-closing mechanism.
Overconfidence means holding concentrated positions and it generally results in trading excessively. A good streak does not mean that it will always be the case and thus, the trader must always follow procedures and ensure he does not stray from the strategy.
We have to make sure to keep our emotions under control by automating our risk management procedures.
6. Not Sticking to Your Plan.
When you design you trading strategy and risk management system, you have to stick to it. Otherwise, you will not be able to properly evaluate your performance. Discipline is paramount with trading and the more disciplined you are to your trading system, the more you’re likely to succeed. A plan is what validates your choice to trade and consistency is what will make you improve over time.
Of course, if your system needs tweaking or improvements then it is absolutely normal to do so, however, doing so frequently will hurt your results over time. Make sure you make all reasonable efforts to create a robust system that is reviewed periodically and not before every trade you take.
5. Following Other People’s Recommendations.
I cannot stress enough how much this practice leads to capital loss. The problem does not just lie with the bad recommendations or scams, it lies with the fact that every trader has a different risk and holding period profile. Here’s a bunch of reasons why following signals and recommendations is a bad thing:
Scammers that claim 80–90% accuracy on their signals: Let’s face it, there is an abundance of scammers that want you to join their paying service and promise you astronomical profits and accuracy with their signals. Never believe this, no matter which screen capture they show you (I can easily make a fake demo trading account in a few minutes and then show you incredible profit then claim I can always do this). Take this seriously if you want to preserve your capital. Think about it, if these signal providers were so amazing in getting an accuracy that dwarves the big hedge funds and even the great Jim Simmons of Renaissance, then why aren’t they using their own signals to get rich? Why are they clinging to your $9.99 subscription per month?
Different risk profile: Traders and investors can range between risk-averse and risk-seekers and as such, you are likely to be given a signal/recommendation that does not suit your profile.
Different holding period: The recommendation can have an expected time horizon of 1–2 years while you have a maximum of 1 month patience to hold the trade. Not to mention that some trades such as FX have costs over time.
Conflict of interests: This is self-explanatory. Ethical behavior and the absence of conflict-of-interest is key to providing good research and recommendations. Unfortunately, this is not the case in many retail and professional opinions.
You have to be very careful here and only use your own research. Signals and recommendations should not be taken as investment advice, they are simply the opinion of other people, and other people are not always right.
4. Using Excessive Leverage.
Leverage is a way to magnify profits but it is a double-edged sword as it can also magnify losses. Leverage is simply using borrowed funds to increase your position size that is naturally unobtainable through your current funds. If we use it wisely (i.e. not excessively and by respecting proper risk management practices), then leverage can help us achieve our goals quicker, but many traders are so tempted by the size of expected profits through huge leverage that they forget the equally huge expected losses.
FX retail trading generally has leverage from 50:1 to 400:1 which many would consider the latter as excessive. The most common leverage is the 100:1. Let’s explain that in a simple way.
Consider a standard lot on USDCAD of $100,000 that requires you to deposit 1% of margin. This means you have to post $1,000 in order to access $100,000. Hence a 100:1 leverage. The profits and losses are calculated on a $100,000 basis but you only have a capital of $1,000 to play with which means that profits can be high but that also losses can be devastating.
3. Relying Only on Technical Analysis.
Technical analysis is misused. It’s not really a pure prediction tool that is to be used as a standalone strategy. It is a complement to fundamental analysis. In the short-term, it should be used as a part of a system that uses other analyses as well. Here’s a simple example of an overrated element in Technical analysis:
Graphical support and resistance levels.
The intuition that is taught to many novice traders is that: a strong support/resistance level is defined as a level that has been respected by prices at least 3 times and hence the probability that prices react well from it is high.
But is that the way how are we supposed to think about them? Here’s my personal interpretation and opinion: I believe that it’s quite the contrary. When this “support” or “resistance” has already been tested quite a few times, I believe that prices are giving us a signal that they want to breakout and more often than not, they breakout on the third or fourth attempt. This is why graphical supports and analysis do not work (at least over time). A clear ascending channel doesn’t provide support and resistance levels, it provides downside and upside confirmation levels.
This sin does not include automated strategies based on technical signals as they have proven their value and profitability when used correctly.
2. Neglecting Proper Risk Management.
If your trading strategy is what makes you gain money then your risk management is what keeps you from losing money. Markets are random-like environments and we cannot be right all the time, therefore, we must account for the times that we will not get it right. After all, the most successful investors and traders are coincidentally great at managing and measuring their risk. Never forget your stop-loss that is placed carefully by respecting a good risk-reward ratio.
The risk-reward ratio (or reward-risk ratio) measures on average how much reward do you expect for every risk you’re willing to take. For example, you want to buy a stock at $100, you have a target at $110, and you place your stop-loss order at $95. What is your risk reward ratio? Clearly, you’re risking $5 to gain $10 and thus 10/5 = 2.0. Your risk reward ratio is therefore 2.
It is generally recommended to always have a ratio that is higher than 1.0 with 2.0 as being optimal. In this case, if you trade equal quantities (size) and risking half of what you expect to earn, you will only need a hit ratio of 33.33% to breakeven. A good risk-reward ratio will take the stress out of pursuing a high hit ratio.
1. Wanting to Get Rich Fast.
This sin actually is an embodiment of all of the above. The emotional need to make money as soon as possible in order to impress society pushes a trader to make emotional bad decisions with regards to his trades and trading-related activities. This is also related to the fact that with the need to make money, we are likely to keep changing our plan because we believe that the new plan will be a quicker way to wealth.
The fifth sin relates to following other people’s signals and recommendations. When we do not have enough faith in ourselves and think that other people are better than us at making us money, we will follow them, especially because of the abundance of information they provide.
The fourth sin relating to leverage is probably the most relatable. More leverage equals more profits right? Well, as we have explained above, more profits come with more risk. Next comes the sin of relying only on Technical Analysis. This error is due to the fact that many people online are advocating for the success of this analysis and how it made them rich. Remember what we have said about scammers? It applies here too. The road to wealth is slow and steady, it’s not through leverage and Technical analysis tools that have proven their failure many times (Although I do use this technique as a confirmation of my personal trades).
Finally, neglecting risk management is related to a disbelief in the human limitations with regards to forecasting. One such example is moving your stop-loss when the position goes against you because you believe that it will reverse and becomes profitable again. This only worsens the case and causes your risk-reward ratio to decrease.
Patience and discipline are key elements in trading. Forget about the Lamborghini photos you see online, forget about the private jets photos. This is not what trading is about. Most successful traders are silent.