James Brodie
As we have seen in recent years, many new traders get caught chasing the latest vogue stock or asset class, crypto currencies being a great example. Led by hysteria and bogus dogmas such as ‘diamond hands’ and ‘laser eyes’ which are used to ‘teach’ retail traders into a ‘buy and hold’ strategy (i.e., do not sell).
But as Bitcoin fell from a peak of $68,999 late last year to $32,970 just 2 months later, many retail traders were wiped out. In fact, on chain analytics showed us that on May 19th, 2021 (a day of great crypto volatility) 880,000 crypto trades lost their entire equity.
More recently with the S&P composite index trading just 6.2% below it’s all time high (4th January 2022) the internal breakdown of individual stocks is showing far greater weakness.
Recently ‘meme’, crypto, and work from home stocks such as Peloton, Dogecoin, Nikola and Robinhood have all fallen more than 85% from their 2021 peak.
The key to successful trading is risk management, particularly cutting losses and holding profitable trending positions.
However, this is easier said than done, and our own behavioral biases such as loss aversion, prospect theory, self-attribution, over-trading and over-confidence continually work against us.
Related article: Trading and Investing: A Beginner's Guide
Understanding our behavioral biases and controlling our emotions are also key. As Marty Schwartz, a famous stock trader once said;
“Most people think they’re playing against the market, but the market doesn’t care. You’re really playing against yourself.”
Here are some key trading tips for new and aspiring traders.
A fundamental view will not generate a profit, it has to be confirmed by the price action. Short term traders typically use the 5 or 20-day moving average and trade in the same direction as the trend. Trend-following algorithms also use similar metrics which can exaggerate the length of the trend (both price and time), enhancing profits.
“Give up trying to catch the first eighth and the last eighth of a trend. These two are the most expensive eighths in the world.”
~ Jesse Livermore
S&P Index with the 20-day moving average (yellow). Trend following traders will be long as the moving average trends higher, and either short or square (for equities) when the moving average falls. (Source: Bloomberg)
2 Use a Stop Loss to Exit Losing Positions
Always use a stop loss to exit losing positions early before small losses grow into large losses.
A stop-loss is a pre-determined level to exit a trade that is losing money. Our fundamental view and trading position may be correct and making money, but as new information hits the market we cannot know when the position may turn against us. A surprise central bank move, or terror event are classic examples. Stop losses are key to good risk management.
As the famous trader Ed Seykota once said:
“The elements of good trading are cutting losses, cutting losses, and cutting losses. If you can follow these three rules, you may have a chance.”
Cut losses, do NOT add to a losing position, because if a market is trending against you then the losses will multiply rapidly. Profitable trading is about small profits, small losses, and large profits.
4 Stay Patient
Be patient, do NOT over trade. The 10% of traders who put on the most trades have annual returns 7% lower than the 10% of traders who put on the least trades.
Trading and investing should be boring - excitement is for gamblers.
The most common trading process is trend following, let the price action (trend) guide you.
If you have a fundamental view on an asset, then wait until the price action confirms your view before entering the position (with a stop loss attached, for risk management).
6 Mind Your Risk
Never risk more than you expect to gain.
Using the Kelley criterion, the position size per trade should typically be about 2% of investible assets.
New traders typically risk far more than this.
To trade successfully, think like a fundamentalist, trade like a technician.
It is imperative that we understand the fundamentals driving a trade, but also that we understand the market's technical price action.
8 Take Your Time
Be patient. Your aim is to be profitable and not necessarily right. So, trade what is happening, NOT what you think is going to happen.
If you’re feeling anxious, cut your position size. Increase the process and reduce the emotion.
Related article: 9 Behavioral Finance Books Every Budding Trader Should Read
10 It’s a Human Endeavor
An understanding of mass psychology is often more important than an understanding of economics. Markets are driven by some human beings making human errors and by other human beings making incredible insights.
Have a journal documenting all trades. Why they were entered, the position size, stop loss level, where you took profit and why, your emotions, views & feelings.
Analyze the results and learn from the mistakes. You will learn a lot about your approach, system and mind set.
12 Understand the Importance of Mental Capital
Capital comes in two varieties: Mental and physical.
Of the two types of capital, the mental is the more important and expensive of the two.
Holding to losing positions costs measurable sums of actual capital, but it costs immeasurable sums of mental capital.
Ultimately the key to successful trading is a mix of process, discipline, and risk management.
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