Saturday, February 02, 2008

Cross-Talk: Trading Mistakes to Avoid

In these Cross-Talk posts, I'll be commenting on ideas from other bloggers and hopefully stirring a bit of discussion and debate. My hope is that these posts will draw attention to the fine work of bloggers you may not be familiar with.

Chris Perruna has posted a list of trading mistakes to avoid at all costs; it's an excellent list. Note how many of the items pertain to risk management. So much of success is a function of controlling the downside.

Note, too, however, that much of the list focuses on errors of commission, not omission. Chris' admonition "learn to position size" is very important in this respect. Failing to be sufficiently aggressive with good ideas has less visible consequences than being overly aggressive with impulsive trades, but over time it is deadly. I consistently find--in my own trading and that of the traders I work with--that a minority of trades generate a majority of profits. Failure to act on just one or two good ideas can be the difference between profitability and loss.

The mistake of not having clear exit targets (or moving targets impulsively) is also one that greatly interferes with performance. Without a clear stop loss point, the only stop in force is that last exit for the lost: pain. By that time, emotional damage has been done and subsequent trades are apt to be affected. Similarly, knowing where to take profits reinforces a sense of control. Without profit targets, once again the only get-out point will occur with the pain of seeing profits significantly eroded.

One of the interesting items on Chris' list is "buying familiar names". Limiting trades to what is salient--topmost of your mind--is often acting on the obvious, and others have already made that trade. Research from Brad Barber and Terrence Odean suggests that traders tend to buy stocks that have attracted attention, either because of news or abnormal volume. Their work suggests that buying what has already drawn attention is not a money-making strategy. The successful strategies in the market are rarely the obvious ones. When a trend is obvious on a chart, that usually is not the point to jump in; when a range is evident, that isn't the time to fade the extremes with impunity.

Chris' other point is to not trade blindly. I would frame that as "don't trade without preparation". If I haven't looked at the whole market picture--where the strength and weakness lie, where we're in longer-term ranges or trends, how economic reports might impact the market--I am much more likely to make the impulsive trade that misses the big picture. Trading profits have to be earned, and effort is the currency.

More trading mistakes to avoid? I welcome ideas and observations from readers.


The Most Common Trading Problem

Overconfidence and Underconfidence in Trading


The Black Crow said...

[quote]More trading mistakes to avoid? I welcome ideas and observations from readers.

Well actually I have one. It's my opinion that traders who practice a trend following strategy often buy the weaker trending stocks and miss the stronger ones, ending up with less better result than could have been.

I tried to explain this in one of my posts on my blog :

I hope you understand what I mean. As a result I'm not afraid to chaise a stock (of course to a certain extend) and mostly those I had to buy higher / short lower than I expected are the easiest trades.


Adam said...

Brett ~

My “don’ts” come from the point of view of a full-time, at-home trader deploying family capital:

Don’t assume your trading income, if any, can or will replace that derived from a job. Be sure all basic needs are met.

Don’t trade with money you can’t lose. If loss of initial capital will impact your lifestyle, save until it won’t.

Don’t trade undercapitalized. If your stake can’t absorb tuition the market charges to teach, you’ll never learn what it can teach.

Don’t trade to buy stuff. Setting a target of X to make a house down payment will lead to disappointment and failure to focus on the long game.

Don’t trade without agreement or support from your partner or spouse. The need to win approval will make trading erratic and impulsive.

Don’t lie to your spouse or partner about trading losses. Sex and money are the two principal sources conubial strife; truth in both has a huge upside.


Brett Steenbarger, Ph.D. said...

Hi Black Crow,

Great point; the selection of *what* to trade is every bit as important to performance as *when* to enter/exit.


Brett Steenbarger, Ph.D. said...

Hello Adam,

Those are *great* rules. I especially like the last ones relating to integrating trading with your life with your spouse. Lying to spouses about trading losses is a recipe for relationship disaster. Having a spouse who is fully on board with trading plans and who understands the ups and downs of trading is very, very helpful--