In theory at least, trading is very straightforward. We can either buy low and sell high if we expect a market to go up. Or, if we think a market is overvalued, we sell (short) high and buy back lower. It’s easy isn’t it…?!?
Of course, if you have ever done any trading you know this is not the case. The tricky subject of our own psychology gets in the way of the rational approach. I thought it would be useful to highlight what I think are the five major obstacles that we face – and then in further blogs examine these in more detail and look at ways we could try to overcome them.
Trading against the trend
Yes, yes – I know. You have heard this one so many times – “The trend is your friend”. We should trade with the direction of the overall market. So why do so many of us (myself included) struggle with this simple rule?
I think it is one of those things that is wired into us as humans. We see a market that has gone up – and then gone on to go even higher – and our initial reaction is to start picking a top. Or, of course, alternatively, a market that has plummeted and we think it must be a bargain right now. Let’s look at GBP/USD from the end of April 2018. The chart shown is a one hour candlestick chart (each candle represents one hour of trading).
After a decline of around 450 points from the mid April high, GBP/USD did start to stabilise. It would be easy to think that maybe the decline had gone far enough, but the trend was still down. What happened next?
The circle above shows the right-hand side extreme of the first chart. You can see that the trend continued – it actually dropped another 500 points over the next month. Once again, our inability to follow trends has cost us money.
Risking too much on any one trade
Money management is such an important part of trading, but it’s often ignored by those new to financial markets. In the beginning (and sometimes for much longer) we are too focussed on what time frame to use for our candles, what moving average we should be using and what colour should the Bollinger Bands be, that we ignore this basic fundamental. How much should we risk on any one trade? Too many of us never give this a second thought.
To take this to one extreme, let’s say you have £1,000 in your account and carry out a trade that loses £500. You now need to double your money on the next trade just to get back to the starting point.
Taking profits too quickly
Along with the line “the trend is your friend”, another well-known trading saying is “let your profits run”. This is another simple sentence to say, but usually a little more difficult to carry out in practice. Let’s take a situation where we see a profit of £50, and then watch the market move slightly against the trade. So now we only have £40. The knee-jerk reaction of many traders is to panic and quickly close the trade before the “evil” market takes our profits away.
But really profitable trades can take some time to develop, so learning to “run our profits” is a very important discipline.
Letting losing trades run too far
This is really the mirror image of the mistake above. It is human nature to take profits too quickly and, if a trade turns into a loser, just to wait a little bit longer to see if it turns around. Of course this is the opposite of what we should do as profitable traders. We should be ready to admit we are wrong when the market does not move as we expected. It can be very dangerous to give a trade “just a little more room”, then regret not taking the first loss, and sitting there seeing the losses mount.
This is why setting a stop loss when a trade is opened is usually such a good idea. It enforces the discipline of deciding on a level to get out, if things do not turn out as you expected, and eliminates the chance of second-guessing your decision when the market gets to your stop loss point.
No trading plan
If we are going to travel a certain distance across the country, many of us will use some form of navigation system – it is almost second nature and is a logical part of our plan. But so many of us do not have any sort of plan at all when we choose to enter the market. All of the four previous points are signs of having no real trading plan.
Having a set of conditions that need to be met before placing a trade, for example, trend, stop loss, take profit level, size of trade helps to enforce the all important discipline of trading. As part of this series, I will look at some sample trading plans and how the can be incorporated into your own particular style.
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