There are certain mistakes that day traders make that, if made regularly, are likely to empty his account. Traders often use strategies to try and exaggerate their returns, but the following methods often result in lower returns, or even losses.
1. Averaging down
Averaging down is when a trader adds to a losing trade to bring down the average value of the units in his position.
If we use share trading as an example, a trader might have 1000 Qantas shares he bought at AUD2.80. When they dropped to AUD1.50, he bought another 1000. This makes the total cost of his position ADU4,300 ([AUD2.80 x 1000 shares] + [AUD1.50 x 1000 shares] = AUD4,300), and the average value of each share AUD2.15. This means that the share price no longer needs to rise above AUD2.80 for him to make a profit, it only needs to rise to AUD2.15.
If the share price then falls to AUD1.00 he might buy another 1000 shares, bringing the total cost of his position to AUD5,300 and the value of each share AUD1.77. The shares will have to rise by 77 cents for the trader to break even, and more for him to make a profit. Although this is possible, there is no telling when the market might turn to that degree, and the trader is more likely to make a loss than a profit.
When it comes to instruments traded on a margin, such as CFDs on shares or forex, a trader can access a wide position for a relatively small deposit. Although this can magnify the return on his initial investment, it will magnify his losses to the same degree.
If you were to trade Qantas share CFDs rather than Qantas shares, you could open a position with a deposit that is only a fraction of the value of the position. For this example, we’ll assume a margin requirement of 5%, meaning that your initial position on 1000 shares valued at AUD2.80 could be opened with a deposit of AUD140 (AUD2.80 x 1000 x 5% = AUD140).
When the shares dropped to AUD1.50, you could open a position on another 1000 shares with a deposit of AUD75. When the shares dropped again to AUD1.00, you could open another position on another 1000 shares for AUD50.
You have paid a total of AUD265 for your positions on 3000 Qantas shares. As the share price has dropped to AUD1.00 per share, the total value of your positions is AUD3,000. The average value of each share based on their initial prices is the same as it was when you were trading conventional shares: AUD1.77.
If the share price rises to AUD2, you could close your positions on 3000 shares for AUD6,000, whether you were trading shares or share CFDs (excluding commissions, financing charges and dividends). To buy 3000 shares you needed to pay a total of AUD5,300, leaving you with a profit of AUD700.
However, when trading CFDs you only made a deposit on AUD265, leaving you with a profit of AUD5,735.
This example reveals why it is so tempting to average down with geared products like CFDs; if you are depositing so little, why not?
Because you can lose just as much as you can gain.
If the share price had dropped again to AUD0.95 you may have decided to take the loss. The 3000 shares would now be worth AUD2,850. In conventional share trading you would have lost AUD2,450, or 46% of your investment of AUD5,300.
You would have lost the same amount when
trading CFDs. As share CFDs mirror every aspect of share trading, the opening value of each position was the same as the opening value of every thousand Qantas shares you would have purchased conventionally. The first thousand were worth AUD2,800, the second thousand were worth AUD1,500 and the third thousand were worth AUD1,000. This means you also lost AUD2,450. However, where that was 46% of your investment in shares, it is now 924.5% of your AUD265 investment in CFDs.
Although some traders might be tempted to keep averaging down until the market turns, this is not advisable. When, or even whether, the market will turn is never certain, and sustaining such a great loss in respect to your initial investment can leave you subject to a margin call.
Prepositioning for news
News events can often have a large impact on the market, and traders can make great profits if they use this in their trading.
However, more often than not, the direction in which the market will move is not known in advance.
Something quite simple, like an interest rate announcement, might be expected to appreciate or depreciate a forex pair, but the trader cannot know what additional statements, figures or forecasts will accompany it.
Frequently volatility surges following a large announcement, and it is difficult to determine a trend in the market, or even if the announcement resulted in a trend following the initial volatility. For these reasons, taking a single position before a news announcement can jeopardise a trader’s chance of success.
One strategy for trading an upcoming announcement is using a spread, which may reap profits as long as the market moves, even if you don’t know the direction it will take.
Trading right after news
News announcements can result in large volumes of trades in both directions, meaning that many traders will make losses as it swings back and forth. Entering a trade like this without any risk management, such as using stops and limit orders can result in you losing more than you wanted to risk. In fact, entering a trade like this with stop and limit orders can result in your stops being triggered over and over as the market swings back and forth.
Day traders wanting to trade economic announcements should watch the market after the announcement has been made, and take a position after the initial volatility has subsided.
Risking too much
As seen when discussing averaging down, risking large amounts does not equate to proportionate returns. All traders lose at some point, and those who risk large amounts of capital on single trades will be hit harder than most as they will lose a larger percentage of their account.
A common rule of thumb is that a
trade should risk no more than 2% of his capital on a single trade, though some traders set lower limits.
It is also a good idea to set limits on the amount you are willing to risk over a certain period. In day trading, it is a good idea not to risk more than 1-2% a day. So, if you made four trades a day with a 1% limit on your risk for the day, each trade would risk 0.25% of your account.
The amount you are willing to risk will depend on your profit targets, your level of capital, and whether you are trading intra-day or over a few weeks or months. Just keep in mind the amount you are willing to lose, rather than potential profits that may not eventuate.
Unrealistic expectations
Unrealistic expectations are usually the foundation of the previous four mistakes:
1. The trader who unrealistically expects the down-trending stock to turn around and win back his losses
2. The trader who thinks he can predict the market reaction to news and make large profits (admittedly it has been done, but is very risky)
3. The trader who immediately trades after an announcement, expecting to make a larger profit by jumping into the trade sooner
4. Expecting eventual profits to offset high levels of risk
Unfortunately the market doesn’t take our expectations into consideration. It is largely driven by people, who are also illogical, so being able to profit on every single move is not possible and will result in errors of judgement.
Conclusion
The best way to avoid these mistakes is to create a trading system and then stick to it. Your trading system should cover your criteria for entering and exiting trades as well as the amount you are willing to risk and profit targets, which will assist you in placing trades as well as stop losses and limit orders. If it yields consistent profits, don’t change it.
Using a combination of
fundamental and technical analysis can help you plan trades and evaluate possible market reactions to events, but if the signals you are using don’t back up what you think will happen, then it is safer to follow them and stay out of the trade. Likewise, if your stop is about to be hit, don’t move it in the hope that the market will turn! The hardest part of using a trading system is following its rules in all situations; but doing it will reward you with more consistent profits over time.
