BY DEFINITION, TRADING is about assuming risk. Like walking a tightrope or having unprotected sex, it only takes one trading misstep to wreck your life. This is a game that should be played carefully at all times.
Although the market is always unpredictable, trading technique can be controlled. To that end, I’ve observed (and, cough cough, committed) a number of common trading traps that will doom an account regardless of what the market does. In hindsight, I’ve learned that most of the frequent mistakes are also the easiest to avoid.
As Sun Tzu observed, the battle is won or lost before the fighting even begins. If you trade for money, let me assure you that the undercapitalized trader is trapped no, absolutely doomed, from the start. It’s not that the game is rigged against the little guy, but rather that there’s an inherent cost to trading. If you have no savings, hold high-interest debt or possess only a few hundred dollars to your name, my advice would be to invest nothing. If you can’t pay, you can’t play. No matter how good your stock-picking prowess, everybody needs to have a financial ark.
The most obvious cost in trading, of course, is the commission. Even at discount rates, this expense adds up quickly for active traders. A less-often considered cost is peace of mind. Plenty of people insist on trading with money they can’t afford to lose. Because the thought of a loss is so psychologically uncomfortable, they essentially hang themselves, ending up with big losses because they were too scared to take small ones.
As we pointed out a few years back, having a small stake doesn’t mean you can’t have a strategy. But, generally speaking, before you invest some cash, start by saving it. Personally, I wouldn’t begin trading unless I, at minimum, had: three months’ worth of living expenses in the bank, at least $5,000 of total risk capital and no credit-card debt.
Another trap involves security selection. For some reason, once people build up enough savings and risk capital to start trading, they all seem to want to start in exactly the wrong place: low-priced or penny stocks. I don’t know whether they just rented “Boiler Room” or simply don’t know much about math. I do know that these people live in a fantasy world where there’s something obscenely appealing about owning 20,000 shares of a stock, even if they are worth only a few pennies apiece.
Maybe it’s just my personal bias coming through, but I’ve never had any success in penny stocks. History will show that I like less-liquid names, but because so many have no nonspeculative volume, trading them on a short-term basis never seems to work. And from an investment perspective, they never turn out to be the dazzling values the low prices suggest them to be. Truth be told, most go nowhere at all.
While the Pink Sheets and OTC Bulletin Board are attempting to become home to more-legitimate listings, I have found that most penny stocks remain penny stocks. After all, what makes a stock move is a shift in the demand or supply. And the big institutions that actually control the big bucks have never liked penny stocks. Looking for income from penny stocks? Don’t even think about it. There are plenty of other high-probability trades out there, and for me the trick is finding the strongest names, not the cheapest ones.
Without question, however, the biggest trap is that of overtrading. Plainly put, it’s expensive, anti-trend and a sure way to ruin an otherwise smartly allocated portfolio.
As we often point out, most of the time a trader should be observing a market, not necessarily trading it. Just because a stock is in the news or on the move doesn’t mean you need to buy it. When it comes to your portfolio, often less is more.
The market moves in trends. Although profits can be gleaned through short-term trading, I’ve had the most success when I’m fortunate enough to get a winning trade and not stand in its way. Just think of “taking” as another word for “stopping.” Take a small loss and you’ve stopped it from growing into a bigger one. But take a gain and you’ve stopped the exact reason you got in XYZ in the first place.
Simply put, overtrading puts you in the position of constantly having to come up with winning trade ideas. But the real challenge of trading isn’t having the skill to find winning trades, but rather having the patience to hold on to the ones you’ve already got. Many of the best trades are the ones you’ll never make.
What makes traps so dangerous is that they don’t appear until it’s too late. But when it comes to making money, there are a few pitfalls that are best avoided from the start. And because trading success is a function of technique, not security selection, the best way to avoid a hole is to sidestep it entirely.
– Originally on Apr 28, 2003 by Jonathan Hoenig
