Many individuals think that short-term trading offers the keys to riches. They often read a book, or perhaps they skim a web site, and realize that technical analysis has countless tools available to unlock those riches. Armed with superficial knowledge and overwhelming greed, they begin their trading career and most, unsurprisingly, end up losing their initial investment in short order.
These would-be millionaires fail to consider that the markets are deceptively difficult and all too often, these ill-prepared traders succumb to one or more of the common errors that can prove fatal to a trading account.
1. Believing in the “Well Chosen” example
Any of the most commonly available technical indicators works well at least once. And it is relatively easy to use charting software to find a spectacular winning trade. All too often, books and magazines include an example of only that breathtaking winner, and ignore the plentiful losing signals. The truth is most trades win or lose only a small amount. To avoid the error of believing everything you read, you need to backtest any idea before putting real money against it. This can be done with software or by paper trading.
2. Relying on a single indicator
There is no simple path to success in trading, although many seem willing to sell false hope for as little as $1,995. When looking at a price chart, it is easy for new traders to become overwhelmed by all the seemingly random wiggles that define market action. An indicator usually smoothes that chaotic path and makes it appear to be understandable. However, bringing a sense of order to the chart comes with a price. All indicators are mathematical manipulations of price, and the calculations can introduce order where none exists. Confirming signals generated by one indicator with another indicator using different calculation methods can prevent taking trades destined to lose by the vagaries of math.
3. Using too many indicators
While one indicator is too few, ten is definitely too many. Actually anything over three indicators is probably too many. Many novice traders add an indicator each time they have a losing trade, and end up with information overload. When three indicators saying buy are opposed by three sell signals, the result is “paralysis by analysis.” Avoid making your charts look too complex. The best traders can often describe their systems so anyone can understand them.
4. Failing to align the indicator with the market trend
Some indicators work best in trending markets and others work best in range-bound action. Using a trend following indicator is a recipe for disaster if prices are bouncing back and forth between clear support and resistance levels. Trending markets tend to offer an extraordinary number of overbought or oversold signals on indicators designed to trade directionless markets. This will put you on the wrong side of the market and you usually won’t get a reversal signal until losses have become very significant. You must know your indicator as well as a mechanic understands how an engine works.
5. Trading against the trend
Any experienced technician will tell you that, “the trend is your friend.” Trading with the trend is the most likely path to success. In a bull market, it is foolhardy to short stocks just because they are overvalued. Internet stocks were certainly overvalued in 1999 but simply became outrageously overvalued in early 2000. Likewise, profits will be easier to make on short trades in a bear market. In 2008, the major stock market averages never rose above their 200-day moving average. This moving average is a great indicator of the long-term price trend. The markets fell by more than 30% in that year. Winning short trades were obviously easier to find in an environment like that. Yet most traders suffered losses as they went against the trend and bought stocks that were falling. The trend is the first thing you need to understand before you can succeed in trading.
6. Following emotions rather than signals
Even the best laid plans can result in losses if they aren’t followed. The best trades are often the most difficult to take. And while we are in a trade it is easy to let emotions get the better of us and ignore a stop loss point believing that we are right and the market will turn around. In trading, it is better to make money than to be right and as traders we need to remember that only the market is right. When your trading plan gives a signal, assuming you developed that plan with good logic and proven to yourself that it delivers long-term success, you must be prepared to blindly follow your signals and ignore your emotions. Greed and fear often represent the most powerful impediments to success in trading.
In the end, trading success can be achieved by anyone willing to work hard and overcome their emotions. Technical trading is not as simple as it looks. But understanding the most common mistakes can help us avoid them.