Traders generally buy and sell securities more frequently and hold positions for much shorter periods than investors. Such frequent trading and shorter holding periods can result in mistakes that can wipe out a new trader’s investing capital quickly. Here are the 10 worst mistakes made by beginner traders:
- Letting losses mount: One of the defining characteristics of successful traders is their ability to take a small loss quickly if a trade is not working out and move on to the next trade idea. Unsuccessful traders, on the other hand, get paralyzed if a trade goes against them. Rather than taking quick action to cap a loss, they may to hold on to a losing position in the hope that the trade will eventually work out. In addition to tying up trading capital for an inordinate period of time in a losing trade, such inaction may result in mounting losses and severe depletion of capital.
- Failure to implement stop-loss orders: Stop-loss orders are crucial for trading success, and failure to implement them is one of the worst mistakes that can be made by a novice trader. Tight stop losses generally ensure that losses are capped before they become sizeable. While there is a risk that a stop order on long positions may be implemented at levels well below those specified if the security gaps lower, the benefits of such orders outweigh this risk. A corollary to this common trading mistake is when a trader cancels a stop order on a losing trade just before it can be triggered, because he or she believes that the security is getting to a point where it will reverse course imminently and enable the trade to still be successful.
- Not having a trading plan or sticking to one: Experienced traders get into a trade with a well-defined plan. They know their exact entry and exit points, the amount of capital to be invested in the trade, and the maximum loss they are willing to take, etc. Beginner traders may be unlikely to have a trading plan in place before they commence trading. Even if they have a plan, they may be more prone to abandon it than seasoned traders if things are not going their way. Or they may reverse course altogether (for example, going short after initially buying a security because it is declining in price), only to end up getting “whipsawed.”
- Averaging down (or up) to redeem a losing position: Averaging down on a long position in a blue-chip may work for an investor who has a long investment time horizon, but it may be fraught with peril for a trader who is trading volatile and riskier securities. Some of the biggest trading losses in history have occurred because a trader kept adding to a losing position, and was eventually forced to cut the entire position when the magnitude of the loss made it untenable to hold on to the position (or alternatively, because his bosses discovered the true extent of the trading loss). Traders also go short more often than conservative investors, and “averaging up” because the security is advancing rather than declining is an equally risky move that is another common mistake made by the novice trader.
- Excessive leverage: According to a well-known investment cliché, leverage is a double-edged sword, because it can boost returns for profitable trades and exacerbate losses on losing trades. Beginner traders may get dazzled by the degree of leverage they possess, especially in trading, but may soon discover that excessive leverage can destroy trading capital in a flash. If leverage of 50:1 is employed – which is not uncommon in retail trading – all it takes is a 2% adverse move to wipe out one’s capital.
- Trading too frequently: Overtrading can erode returns to the point where nice profits turn into significant losses. While experienced traders have generally learned the hard way that trading too frequently can be severely detrimental to overall returns and performance, new traders may have yet to learn this lesson.
- Following the herd: Another common mistake made by new traders is that they blindly follow the herd, and as a result they may either end up paying too much for hot stocks or may initiate short positions in securities that have already plunged and may be on the verge of turning around. While experienced traders follow the dictum of “the trend is your friend,” they are accustomed to exiting trades when they get too crowded. New traders, however, may stay in a trade long after the smart money has moved out of it. Novice traders may also lack the confidence to take a contrarian approach when required.
- Shirking homework: New traders are often guilty of not doing their homework or not conducting adequate research before initiating a trade. Doing homework is critical because beginner traders do not have the knowledge of seasonal trends, timing of data releases, and trading patterns that experienced traders possess. For a new trader, the urgency to put on a trade often overwhelms the need for undertaking some research, but this may ultimately result in an expensive lesson.
- Trading multiple markets: Beginner traders may also flit from market to market, e.g., from stocks to options to currencies to commodity futures, to name a few. However, trading multiple markets can be a huge distraction and may prevent the novice trader from gaining the experience necessary to become a specialist and excel in one market.
- Overconfidence or hubris: Trading is a very demanding occupation, but the “beginner’s luck” experienced by some novice traders may lead them to believe that trading is the proverbial road to quick riches. Such overconfidence is dangerous as it breeds complacency and encourages excessive risk-taking that may culminate in a trading disaster.
Bottom-Line: Trading can be a profitable endeavor, as long as the trading mistakes mentioned above can be avoided. While traders of all stripes are guilty of these mistakes from time to time, beginner traders should be especially wary of making them, as their capacity and capability to bounce back from a severe trading setback is likely to be much more restricted than with experienced traders.