Chapter 21
IN THIS CHAPTER
Trying to trade tops and bottoms (no, this isn’t X‐rated)
Becoming attached to your trading systems and your stocks
Making decisions on the fly
Losing too much
This chapter introduces you to ten (more, actually) huge trading mistakes that befall experienced and novice traders. We offer suggestions for helping you recognize the mistakes and for avoiding and even correcting them.
Bottom fishing — trying to catch a stock as it bottoms out — is a great way to get soaked and lose a bucketful of money. In a bear market, stocks get much cheaper than most people ever expect or want. They don’t stop falling until they’ve run out of gas.
The psychology of a bear market is perverse. As long as traders remain interested in a stock, many are the moments when it seems like the stock may recover. The thing is, stocks rarely turn on a dime and head higher. Only after the momentum crowd loses interest does the stock’s downward price slide end. When value investors, who can’t resist a bargain, begin nibbling, the stock begins to stabilize; however, it also may spend a very long time bouncing around in a trading range.
Traders have few, if any, reasons for entering the market when a stock is trading in a range. Your best opportunity for profit occurs when the stock breaks out of its trading range. Chapter 9 shows how to identify these trading‐range breakout patterns. Instead of risking your trading capital on unreliable bottoming patterns, wait until you’re sure.
Tops and bottoms share something in common: They rarely arrive when they’re supposed to. When traders and investors are exuberant, they keep buying even after doing so no longer makes fundamental sense. That’s why shorting a stock that’s trending higher makes no sense, even if its price is far beyond reasonable.
You don’t have to have a lengthy memory or an encyclopedic knowledge of stock market history to remember what happened to Internet stocks in the late 1990s. Those were heady days. Stocks went in only one direction — up. Some of those magically levitating companies had modest revenues, but few had earnings. Nevertheless, traders bid hundreds of dollars per share for some worthless junk. Just like the housing bubble of the early 2000s, Internet stocks were a case of mass hysteria, mob mentality, market madness, or all three.
Call it what you will, but when a bubble is inflating, you definitely don’t want to short related stocks. Sure, these stocks eventually crashed and burned, but not before depleting the trading accounts of a den full of bearish short sellers. Don’t guess. Wait for reliable trading signals, like the ones discussed in Chapters 9 and 10, before entering a position.
You may be asking whether there were reliable trading signals before the Internet bubble burst. There weren’t before; traders aren’t fortunetellers (see Chapter 8). However, the risks at the time were well‐known. And when stocks began heading lower early in 2000, you had all the information you needed to protect your profits and trading capital and begin selling short. The signals were also there in early 2008 that the market was set for another fall. Chapter 13 uses the NASDAQ bubble as an example to show how to evaluate market risk and adjust your trading strategy as the market transitions from a rising to a falling market.
Trading against the dominant trend in the market leads to costly mistakes. Unfortunately, misidentifying the trend by focusing on the chart in front of you and forgetting to look at the next higher‐level chart is an easy thing to do. You may see a promising uptrend occur with a pullback on the intraday charts. But on the daily chart, the trend you saw on the intraday chart actually turns out to be a consolidation rally during a strong downtrend. The promising pullback actually is the beginning of the next leg down on the daily chart. If you buy long in a situation like this one, hoping to capture the next leg up, your position will be swamped (and so will your trading capital) by the flood of sell orders coming from traders who recognize the implications of the stronger, longer‐term trend.
Regardless of the specific indications of the chart you’re looking at, always confirm your analysis by looking at charts that are one time period higher. For example, if you’re studying daily charts, confirm your analysis on the weekly charts. If you’re studying intraday charts, confirm your analysis on the daily charts. Always know which part of the market cycle you’re in and what types of industries excel in that part of the cycle. See Chapters 10 and 13 for additional information.
Don’t try to buy long based on a brief intraday move when the dominant trend on the daily charts is down. Doing so is a great way of giving up your trading capital to someone else.
Traders get into big trouble when they wing it. Maybe you heard the guy on business TV say the stock was hot and heading higher. Maybe you saw the news that a new product was bound to be a big hit. Although that may sound like great information, instead it’s only a reason to look into the fundamental and technical conditions of a company’s stock, not a reason to buy today.
Devise a strategy. We think that’s such great advice, we’ll say it again. Devise a strategy. Develop and test a trading system that matches your goals and personality (see Chapter 16). Plan your trades and execute your plan. Wait patiently for your signals to trigger your trades. Pick your entry and exit points before entering your order. Have a plan and stick to it.
Traders also get into trouble when they start second‐guessing their trading plans. Sometimes, even in the middle of executing a trade, you need to make a decision but aren’t sure which decision is right.
When in doubt, close the position. Thinking clearly is easier when your money isn’t at risk. You can always buy back the stock if further analysis confirms it’s the right thing to do.
A losing trade is bad for your trading account, but you can’t let it get to you. Sure, it makes you feel bad, but a losing trade doesn’t impugn your honor or disparage your heritage. A bad trade may reduce your net worth, but it shouldn’t damage your self‐esteem. Entering a losing trade certainly doesn’t mean that you’re a nincompoop or blockhead — any more than closing a winning trade signals your brilliance and mastery of all you survey.
The market isn’t out to get you; it’s out to get your money. Don’t take trading personally. A losing trade is just another losing trade. You’ll have plenty of them. Get used to it.
Trading is a business. Your stocks are your inventory. Smart business owners don’t fall in love with their inventory. It’s there to sell, at a profit if possible, at a loss if necessary. And smart businesspeople don’t fall in love with their business models. If it isn’t working, they change it; otherwise, they’ll be out of business before you can say “liquidation sale.”
When you fall in love with your stock, you risk large losses. When you fall in love with your trading plan, you risk many more losses. It’s easy to fall in love. After doing hours of research and analysis, you want to be right. You want your trades and your trading plans to generate profits, but hoping doesn’t make it so.
Be smart. Don’t fall in love. Your trading system doesn’t have feelings, and your stock won’t love you back. Be prepared to jettison positions and trading systems that don’t do what they’re supposed to do. See Chapter 12 for more about trading as a business and effectively managing your inventory.
When the market opens and it’s off to the races, the market order that you placed last night before going to bed is going to be swept up in a wave of frantic trading. Bad fills are sure to be the result. You’re likely to pay considerably more to buy a stock that you want or to sell one for considerably less than you’d planned. You should never place a market order when entering trades after the market is closed (after hours). Instead, define how much you’re willing to buy or sell a stock for by using a stop order, a limit order, or a stop‐limit order. Chapter 15 discusses the mechanics of entering these types of orders.
If you miss the breakout entry point for a stock that you want, waiting is better than entering a position as a trend accelerates. See Chapter 10 for information about identifying and trading a trend. Often, stocks will pull back and test the breakout point. Wait for that point, or wait for the stock to take a short breather after its first leg up. If you’re still interested, that’s a better entry point than chasing a stock as it accelerates into the trend. Like a fine wine, you sometimes need to let a stock breathe.
On the other hand, if you already have a position in a runaway stock, try planning your exit so you leave a little money on the table. Capturing every last nickel of the trend is almost impossible, anyway, so don’t try. Instead, consider trimming your position as the stock reaches for the stratosphere. If you’re using margin, consider taking some profit off the table and reducing your leverage a bit. We discuss this strategy further in Chapter 13, and the mechanics of using margin are covered in Chapter 15. When a runaway stock stops going up and everyone wants out at the same time, the speed at which the price falls is remarkable. Be ready to jettison stocks that rally too fast at the first sign of trouble.
Averaging down is a below‐average idea. You sometimes hear advisors suggesting it as a way of reducing your cost basis, but it’s merely a technique to throw good money after bad. The logic of averaging down is completely contrary to the logic of trading. Traders sell losers. They don’t reward them with infusions of trading capital.
However, averaging up makes some sense. Traders call it pyramiding. The idea is to add to your winning positions when your trading system triggers new trading signals in the direction of the trend. Pyramiding is a good way of building a large position in a strongly trending stock. Be aware of the risk, though. The larger your position, the more it hurts when the trend ends and the stock’s price begins to fall. Be ready to trim your pyramid position at the first sign of trouble.
Talking yourself out of honoring your stops is an easy thing to do. You’ll be tempted when a trade goes against you. You’ll look at your indicators and the support levels on your charts, and you’ll be certain that the stock soon will stop falling. When you start thinking you want to give a position a little room to work its way out of losing territory, you’re on your way toward a trading debacle. It’s wishful thinking, it’s hoping against hope, and it’s a good way to lose a lot of money. Unless you’re omniscient, close the position when the price hits your stop. Take your loss. Chapter 15 discusses stop orders and how to use them.
Exposing all your capital in one trade is a bad idea, and so is trading hundreds of stocks simultaneously. You can find a happy medium somewhere in between.
You can monitor only so many positions and do it well. You need only so many positions to diversify your risk. And although you can have too few or too many stocks in your trading portfolio, no perfect number — one that is right for every trader — exists. That said, you nevertheless have to figure out what the right number is for you. Start with 10 or 15 positions. You may end up deciding that 8 are enough. However, unless you have an extremely large portfolio, we can’t imagine why you’d need any more than 20 positions.
The simple wisdom is this: Don’t put all your eggs in one basket. And don’t chop your eggs into little pieces and spread them across many dozens of baskets. You want to diversify — just not too much.
To trade is to lose. No matter how good your trading system is, no matter how experienced you are, and no matter which stocks you pick, you’re going to have losing trades. Your success as a trader depends on how you handle those losing trades. If you dispose of the losers quickly, you can become a very successful trader. But if you hold on to those losing positions, you can lose so much money that it may knock you right out of the trading business.
Using margin (see Chapter 15) exacerbates the problem of losing trades. Margin is a wonderful thing because with careful application it can magnify your profits. But on the flip side, with indiscriminate use it can also magnify your losses. If you want to turn your pool of trading capital into a puddle, leverage a lot of losing trades.
Small losses won’t hurt you much, but large losses will. If you use margin and fail to cut your losses, you won’t be a trader for long.