IN THIS CHAPTER

Avoiding other people’s trading mistakes

Steering clear of psychological and preparation mistakes

Day trading is tough. Many popular markets are zero-sum games, meaning that for every winner, there’s a loser. Other markets, such as the stock market, are positive-sum games, meaning they have a tendency to increase in value over time, but you may rarely see big moves in any one day. And the whole point of day trading is to close your positions each night. Most day traders lose money, in part because they make obvious, avoidable mistakes.

This list of ten mistakes can help you avoid the most serious ones. Avoiding these mistakes is no guarantee that you’ll make money trading, but it can certainly reduce your risk and improve your odds. And that’s half the battle.

Starting with Unrealistic Expectations

Most day traders lose money. Some research shows that 80 percent of day traders wash out in the first year. Brokerage firms that deal with day traders are constantly figuring out ways to attract new customers, because it is so hard to retain the ones they have for the long term.

Yes, some traders make money. A few make a lot of money. But they are the exception. Making money day trading is tough, making enough money to cover the value of your time is even tougher. If you go into trading knowing that it’s hard, that you should only risk money that you can afford to lose, and that you need to think about it as a business, you’ll have a leg up on those who think that they’ve found an easy way to make millions from the comfort of their own home — and who are then stunned to discover they are broke.

Beginning without a Business and Trading Plan

Trading is a business. When you decide to day trade, you are committing capital to an entrepreneurial business with a high risk of failure. You are no different from your brother-in-law who decided to open a sandwich shop franchise, your neighbor who joined a startup company for little salary and lots of equity, or your college buddy who has been trying to make a go of it as a full-commission life insurance salesman. You are all out on your own, risking your capital in the hope of great success but knowing that many others doing the same thing fail.

Successful businesses have business plans, and your trading business is no different. You need to specify what you are going to trade, when you’re going to trade, how you’re going to trade, and with how much money — before you get started. You need to determine what equipment you need, what services and training you want, and how you will measure your success. Chapter 14 can help you with a business plan, and the rest of the book can help you fill in the appropriate sections of it. Having the plan will keep your expectations in line and create a professional starting point for your new trading venture.

You also need to supplement your business plan with a plan for your trading. How are you going to trade? What signals will you watch for? Under what conditions will you enter a position, and under what conditions will you close it? That’s your trading plan. Good traders have trading plans so that they know exactly what they want to do when they see opportunities in the market. This plan reduces the fear and doubt that can unsettle most traders, and it heads off the panic that destroys more than a few. Read Part II of this book for ideas on trade strategies.

In addition, good trading plans have to be tested and evaluated. Chapter 13 has good information on testing and evaluation so that you have enough confidence in your system to follow it, even when the market gets squirrelly on you.

Failing to plan is planning to fail, as the cliché goes. You are risking too much of your hard-earned money to skip careful upfront planning. Take responsibility for your trading.

Ignoring Cash Management

Because financial markets can be volatile, you can easily get wiped out. Good cash management can help you stay in the game. Because you never commit all of your capital to any one trade, no one trade can shut you down. At times — like when you know you’ve got a great idea — holding back some cash may not seem right, but if you plan to trade for the long run, you need to follow your money-management strategy. Otherwise, you’ll never be able to get a winning trade that can offset your losses.

You need to have your wits about you to day trade, but you also need to have capital. Chapter 6 has some great information on cash management, so don’t skip it!

Failing to Manage Risk

Day trading is risky business, and most day traders quit because of losses. (Have I told you that already?) Even traders who stick with it have many losing trades. That’s why they have risk-management systems in place. Their trading plans include stops, which automatically execute buy or sell orders when securities reach predetermined levels. (Stops are discussed in Chapter 7.)

The day trader looking for trouble places orders without thinking about how much of a security to buy or sell at any one time, and she thinks that she’ll just know when to sell. And then she second-guesses herself and finds herself with bigger losses than she intended.

If you’re going to day trade, be safe. You know what the risks are (that’s why you picked up this book), so use the protection offered by stops and sound money management.

Most day traders lose money. Don’t risk money you can’t afford to lose, and plan for the risks that you take.

Not Committing the Time and Money to Do It Right

Day trading is a job. It’s a small-business endeavor that requires research and training well in advance of the first trade. It’s not something you can squeeze into an hour a day as a hobby. To do well, you need to set regular hours and have enough money to generate reasonable returns without unreasonable risks.

Many people think day trading is something that they can easily enter into and that they can generate profits while their kids are napping. That thinking is a mistake. If you can’t dedicate the time necessary to study the markets and understand how you react to them, you will have trouble staying in the trading business.

Day trading is a business of frequent trades with small percentage gains and a high potential for loss. If you have days of losses, a small account will quickly end up with too little money to meet minimum order sizes. Therefore, successful traders start with enough money to last through periods of drawdown and are still able to generate meaningful dollar returns. Consider this: A 1 percent return on $1,000 is equal to $10, but a 1 percent return on $100,000 is $1,000.

If you have more money to begin with, the dollars you make from day trading will seem more real to you. The U.S. Securities and Exchange Commission and the National Association of Securities Dealers define day traders in part as customers with $25,000 in their accounts. If you have $25,000 you can afford to lose, you are more likely to be a successful day trader than if you have only $2,500 — and you’ll be considered to be a day trader, not a dilettante.

You are going to lose money. All day traders have bad days, and they are more likely to lose money early in their trading careers before they get a feel for the markets and their own reactions to it. If you have enough money when you begin, you can consider these losses to be part of your apprenticeship.

Chasing the Herd

Everyone in the market is looking at the same data and the same technical indicators (like those I discuss in Chapter 8). Good day traders follow market trends but with the goal of being early or on time. Those who get in late get crushed: They buy too high, or they sell too low. Chasing the herd is tempting, because it’s so hard to watch the market move away from you.

Day trading requires quick reactions. It’s video games and psychology, some people joke, because the trader who can figure out what others in the market are doing and then click on the mouse button fastest has a huge advantage. The trader who hesitates or goes along for the ride is likely to be ruined.

There’s no easy solution for this. It helps if you know that you are psychologically cut out for day trading (refer to Chapter 14) and have confidence in the long-term performance of your trading system (refer to Chapter 16). But to a big extent, you just have to have some experience in the markets to know how your trading system matches what’s in your head.

Switching between Research Systems

Day traders lose money, at least part of the time. And losing money can cause a day trader to lose trust in his trading system. And many do what seems logical, which is move to a trading system that seems to be working. The problem is that no system works all the time; if one did, everyone would use it. And sometimes things look their worst before they turn. By switching systems whenever things look bad, the trader never learns the nuances of how a given system works for him. And he’s likely to get stuck on another downtrend, picking up the new system right when the old one starts to work again.

Markets go in cycles. No system works all the time, but if you panic and start trying new things without doing a lot of upfront work, you’re likely to make things worse. Chapter 13 covers performance evaluation and system testing in great detail. The more you understand your system and how it works, the less likely you are to be brought down by floundering around for new systems all the time.

Bottom line: Anyone who has a magic trading system that works in all markets is retired and living on a beach in Maui. Everyone else has to live through a few rough stretches.

Overtrading

Because day traders don’t hold positions for long periods of time, they rarely enjoy big and profitable price moves. Instead, they make money from lots of transactions with small profits. They are crazy people, moving in and out for short periods. But believe it or not, the day trader who trades too much loses out. She won’t be in the market for large intra-day moves, and she’ll get killed on commissions and other transactions costs.

As paradoxical as it seems, many day traders do better by making fewer trades each day. That way, commissions and fees take a smaller bite of the profit. One way to profit from fewer trades is with better money management, discussed in Chapter 6. A trader who puts money to work appropriately can often make more money than one who trades frenetically.

Sticking Too Long with Losing Trades

Day traders are often overcome with fear, doubt, greed, and hope. They are afraid to recognize a loss. They wonder whether they’re good traders. They don’t want to pay the commission to get out of the loser. And if the security was a good buy at the higher price, it’s surely a better buy now that the price has gone down. These traders think that if they just keep a positive mental attitude, everything will work out all right in the end.

Good traders have systems in place to limit their losses. They use stop orders to force themselves out of bad trades. They would rather put the money to work on a good trade than stick out a bad one.

The market doesn’t know your position; even if it did, it wouldn’t care. Therefore, no amount of wishing and hoping will cause the market to reward you for your patience. If a trade isn’t working, get out. As the man in the musical sings, tomorrow is a latter day.

Getting Too Emotionally Involved

Trading is a stressful business. You’re up against an impersonal market that moves seemingly at random (and many academics would say that it moves truly at random). It involves money, which to some people is a way to keep score in life and to others is their primary source of security. Losing trades mean a loss of status and a loss of safety. It’s no wonder that so many traders are head cases when the entire market sometimes seems to be conspiring against you — you specifically.

The best traders are almost Zen-like in their lack of attachment to the market. They are able to remove themselves from the frenzy of the trading day so that they’re not susceptible to fear, doubt, greed, and hope. Chapter 14 has some advice that can help you approach the trading day in a calmer manner. Only you know whether you are capable of that.