Top 10 common trading mistakes and how to avoid them
While some trading mistakes are unavoidable, it is important that you don’t make a habit of them and learn from both successful and unsuccessful positions. With that in mind, these are the 10 most common trading mistakes.
Top 10 trading mistakes
- Not researching the markets properly
- Trading without a plan
- Over-reliance on software
- Failing to cut losses
- Overexposing a position
- Overdiversifying a portfolio too quickly
- Not understanding leverage
- Not understanding the risk-reward ratio
- Overconfidence after a profit
- Letting emotions impair decision-making
We’re going to look at each of these mistakes separately, and show you some techniques for avoiding them so that you can be better prepared during your time on the markets.
Not researching the markets properly
Some traders will open or close a position on a gut feeling, or because they have heard a tip. While this can sometimes yield results, it is important to back these feelings or tips up with evidence and market research before committing to opening or closing a position.
It is essential that, before you open a position, you understand the market you are entering intimately. Is it an over-the-counter market, or is it on exchange? Is there currently a large degree of volatility in that particular market, or is it more stable? These are some of the things you should research before committing to a position.
Trading without a plan
Trading plans should act as a blueprint during your time on the markets. They should contain a strategy, time commitments and the amount of capital that you are willing to invest.
After a bad day on the markets, traders could be tempted to scrap their plan. This is a mistake, because a trading plan should be the foundation for any new position. A bad trading day doesn’t mean that a plan is flawed, it simply means that the markets weren’t moving in the anticipated direction during that particular time period.
One way to keep a record of what worked and didn’t work for you is to have a trading diary. This would contain your successful and unsuccessful trades and the reasons why they were so. This can help you learn from your mistakes and make more informed decisions in the future.
Over-reliance on software
Some trading software can be highly beneficial to traders, and platforms such as MetaTrader 4 offer full automation and customisation to suit individual needs. However, it is important to understand both the pros and cons of software-based systems before using them to open or close a position.
The primary benefit of algorithmic trading is that it can carry out transactions much faster than manual systems. Today, automated trading systems are becoming so advanced that they could be set to revolutionise how we interact with the markets in the coming decades.
However, algorithm-based systems lack the advantage of human judgment because they are only as reactive as they have been programmed to be. In the past, these systems have been seen as responsible for causing market flash crashes, due to the rapid selling of shares or other assets in a market that is temporarily declining.
Failing to cut losses
The temptation to let losing trades run in the hope that the market turns can be a grave error, and failing to cut losses can wipe out any profits a trader may have made elsewhere.
This is particularly true on a day trading or short-term trading strategy, because such techniques rely on quick market movements to realise a profit. There’s little point in trying to ride out temporary slumps in the market, as all active positions should be closed by the end of that trading day.
While some losses are an inevitable part of trading, stops can close a position that is moving against the market at a predetermined level. This can minimise your risk by cutting your losses for you. You could also attach a limit to your position, to close your trade automatically after it has secured a certain amount of profit.
It is worth noting that stops don’t always close your trade at exactly the level you have specified. The market may jump from one price to another with no market activity in between – which can happen when you leave a trade open overnight or over the weekend. This is known as slippage.
Guaranteed stops can combat this risk, as they will close trades automatically once they reach a predetermined level. Some providers charges for this protection upfront. With IG Bank, there will just be a small premium to pay if a guaranteed stop is triggered.
Overexposing a position
A trader will be overexposed if they commit too much capital to a particular market. Traders tend to increase their exposure if they believe that the market will continue to rise. However, while increased exposure might lead to larger profits, it also increases that position’s inherent risk.
Investing in one asset heavily is often seen as an unwise trading strategy. However, overdiversifying a portfolio can have its own problems, as explained below.
Overdiversifying a portfolio too quickly
While diversifying a trading portfolio can act as a hedge in case one asset’s value declines, it can be unwise to open too many positions in a short amount of time. While the potential for returns might be higher, having a diverse portfolio also requires a lot more work.
For instance, it will involve keeping an eye on more news and events that could cause the markets to move. This extra work may not be worth the reward, particularly if you don’t have much time, or are just starting out.
That being said, a diverse portfolio does increase your exposure to potential positive market movements, meaning that you could benefit from trends in a lot of markets, rather than relying on a single market to move favourably.
You can get market updates and news in one place with IG Bank news and trade ideas section.
Not understanding leverage
Leverage is essentially a loan from a provider to open a position. Traders pay a deposit, called margin, and gain market exposure equal to as if they had opened the full value of that position. However, while it can increase gains, leverage can also amplify losses.
Trading with leverage can seem like an attractive prospect, but it is important to fully understand the implications of leveraged trading before opening a position. It is not unknown for traders with a limited knowledge of leverage to soon find that their losses have wiped out the entire value of their trading account.
To avoid this mistake, you should get up to speed with trading on leverage by using our what is leverage guide.
Not understanding the risk-to-reward ratio
The risk-to-reward ratio is something every trader should take into consideration, as it helps them decide whether the end profit is worth the possible risk of losing capital. For instance, if the initial position was £200, and the potential profit was £400, the risk-reward ratio is 1:2.
Typically, experienced traders tend to be more open to risk and have suitable trading strategies in place. Beginner traders may not have as much of an appetite for risk and could well want to steer clear of markets that can be highly volatile.
Regardless of how open you are to risk, you should have a risk management strategy in place during your time on the markets.
Overconfidence after a profit
Winning streaks don’t exist in trading. The euphoria that comes from a successful position can cloud judgment and decision-making just as much as running losses. The buzz from a win could lead traders to rush into another position with their new-found capital without carrying out the proper analysis first. This may lead to losses and could potentially wipe out the recent gains on their account.
Sticking with your trading plan can go some way to combat this. A profit suggests that a plan is working, and should serve to validate your previous analysis and predictions rather than act as encouragement to abandon them.
Letting emotions impair decision making
Emotional trading is not smart trading. Emotions, such as excitement after a good day or despair after a bad day, could cloud decision-making and lead traders to deviate from their plan. After suffering a loss, or not achieving as good a profit as expected, traders might start opening positions without any analysis to back them up.
In such an instance, traders may add unnecessarily to a running loss in the hope that it will eventually increase, but it is unlikely that this will cause the markets to move in a more favourable direction.
Therefore, it is important to remain objective in your decision making during your time on the markets. To cut out emotions from your trading, you should base your decisions to enter or exit a trade on fundamental and technical analysis that you have carried out yourself.
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Conclusion: make your own trading plan and stick to it
Every trader makes mistakes, and the examples covered in this article don’t need to be the end of your trading. However, they should be taken as opportunities to learn what works and what doesn’t work for you. The main points to remember are that you should make a trading plan based on your own analysis, and stick to it to prevent emotions from clouding your decision-making.
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