Here’s a simple guide to losing money in the financial markets. These are the most common mistakes traders make. Most traders make all three, but making even one is a recipe for losing.
TRADING MISTAKE NUMBER 1
Poorly Defined Exit Conditions
Before you enter a trade, you must have already defined your exit conditions. Every trade has at least three exit conditions:
- A Stop-Loss exit – this is the price that tells you, “my thesis is wrong, I need to close this trade at a loss.” The stop-loss order doesn’t have to be in the market, but it has to be a precise number, and the professional trader must make the commitment to close the trade once that price is hit.
- A Profit Target – this is the price you expect to reach to make a profit on your trade. Lacking a clearly defined profit target, you don’t have a clear idea of when to close the trade at a profit and will often let those profits melt away.
- A Trailing Stop Trigger – Once price begins moving in your direction, you want to have a strategy that will protect you so that a small profit doesn’t turn into a loss. You should pick a price somewhere between your entry and your profit target that – once hit – triggers your trailing stop strategy. (You do have a trailing stop strategy, right?
TRADING MISTAKE NUMBER 2
No Thesis
Successful traders can clearly state their “reason why” for the trade. They know how much profit they expect to make if their thesis is correct, how they will know if their thesis is incorrect, how much money they will lose if their thesis is incorrect, and how long they will leave the trade open before they know one way or another if their thesis is correct. Losing traders merely hope.
The five characteristics of a valid trade thesis are as follows:
- It has clearly defined entry conditions. These can be any combination of prices, indicators and/or external conditions that you wish, but they must be clear and unambiguous. You must know exactly why you are entering the trade, or – lacking all the conditions being met – know exactly why you are choosing not to enter the trade. For example, “I will enter this trade long on the first day after the price closes up after having fallen below its 20 day moving average.”
- It has a clearly defined profit target. If you don’t know how much money you expect to make, you have no way of knowing how much money you can afford to risk. For example: “I expect the price to reach the top of the 50 day price channel as of the day the order was opened.”
- It has clearly defined risk. You know how much money you will lose if your thesis is wrong. For example: “I will close this trade if the price drops more than eight percent from my entry price.”
- It has a defined expectancy. You know how much money you will make on average every time you execute this strategy. You will know roughly how many times you will win and how many times you will lose for a given number of trades. You will know your average expected loss per losing trade and your average expected win per winning trade.
- It has a time limit. Sometimes a trade hits none of your exits. In those cases, you also have a time limit set for your trade so that you can close it and move your money to something more profitable. For example: “If none of my exits are hit within 14 calendar days of my entry, I will close the trade.”
TRADING MISTAKE NUMBER THREE
Failure to Test
Many traders will define their exits and their strategies, but never actually test those strategies before putting real money at risk. Any trade strategy that is clearly defined can also be tested against historical data. In fact, without such testing, it is impossible to know the expectancy of your trade strategy.
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