Risking too much
A fundamental problem among traders is that they risk too much on a trade. Human nature means that we are all apt to look at a chart and think: ‘if I’d traded that, I’d have done really well!’ In fact a better approach might be to say: ‘if I’d traded that, how much would I have lost?’ Warren Buffett’s first rule in investing is ‘don’t lose money,’ and this is equally applicable to short-term trading.
Your trading capital is your business capital, and it should not be squandered recklessly. A rule of thumb that many adhere to is that each trade should only risk 2% of your available capital. So, if you have £1000 in your account, you should only risk £20. That way, a losing trade will only reduce your available capital by a small amount. This may well reduce your potential gains, but this is preferable than ‘do or die’ trades that can result in losses of 10%, 20% or much more. Think of it this way – if you lose 50% of your account in one trade because you risked too much, then you will need to double your money just to get back to where you started.
An additional positive of keeping your risk low is that you are far more likely to remain calm during a trade, and avoid the risk of closing out too early because a sudden swing causes your losses to increase rapidly. ‘Scared money never wins,’ runs the old Wall Street adage, and so keeping your trades low-risk means you won’t fall into that category.
Hanging on to their losers
‘Cut your losses and let your winners run’ is a phrase that every trader will have heard at some point. And yet a lot of them will do the exact opposite. They place a trade, without an idea of how much they want to risk (i.e. where to place their stop loss). The trade moves into a loss, but instead of closing it and taking a loss, they allow the trade to run, and run. By some miracle, the price turns around and the loss gets smaller, and then disappears. The moment the trade moves into profit, they close it. Thus, they do the exact opposite of the phrase mentioned earlier, they run their losses and cut their winners.
Doing this means that the loss sustained on unsuccessful trades is likely to be far larger than the wins on successful ones. This is a recipe to lose money very quickly. Instead, look to implement a clear risk-reward ratio. For every point you risk, you should be aiming to make at least two in gains, a 2:1 risk-reward ratio. Even better would be a 3:1 or 4:1. This way, your losses are kept small, while your winners are far bigger. It means that out of every ten trades, six or seven can be losses, since your 3/4 winner will not only recoup the losses, but actually ensure a profit is made overall.
Ignoring the longer-term time frames
Trading can be a fast-paced occupation. But many traders get sucked into using one-minute, or five-minute charts. This obscures the bigger picture. A market may be trending down on a short-term chart, but on an hourly, four-hourly or daily chart a clear uptrend is seen. The longer the trend has been going on, the stronger it is. A dip on a five-minute chart is not likely to be the beginning of a trend change on the daily chart.
It is possible to trade well on short-term time frames, but they require even more iron discipline than that for long-term trades. Targets and stops will be necessarily much tighter, so must be rigidly adhered to. Intraday time frames don’t usually offer much clarity, and can often be noise, as big institutional players and companies use the market to execute business. They also require much closer attention in terms of time in front of a screen, in order to find opportunities.
Longer-term charts allow for the chance to manage risk more effectively, as well. They allow trades to ‘mature’ with sensible profit targets and stop loss areas. A longer-term view also tends to reduce the number of trades placed, since they focus the mind. Studies show that more trading activity does not tend to lead to greater profits, in fact the reverse is usually the case.