Courtesy of CNBC
The Seven Deadly Sins of Trading
by Lewis J. Borsellino
Chief Executive Officer
Borsellino Capital Management, Inc.
Success in trading has as much to do with what you don't do wrong, as it does with what you do right.
Too many times traders, especially novices, have their eyes on the prize. They want to make money so badly that all they can think about is the upside. Guarding against the perils of the downside gets short shrift, which is a recipe for disaster.
Avoid the following deadly sins of trading. Adhere to this discipline to cut your risk and, in turn, keep small losses from mounting into big ones. And follow these rules. You can break them once or maybe twice, and get away with it. But one of these days, the rules will break you.
The Seven Deadly Sins of Trading
Inadequate Capitalization
Lack of Preparation
Risk and Reward Out of Balance
Over-Trading
Trading Without Stops
Averaging
Hurting the Integrity of the Market
Inadequate Capitalization
Whether you're trading stocks that require a 50 percent margin or futures that are leveraged instruments, you need adequate capital with which to speculate - and to provide a cushion against the inevitable losses. As a professional fund manager, my rule of thumb is not to expose any more than four percent of client capital - taking into account slippage (or the difference between where the market is quoted and the price at which a trade is executed) and commissions - to potential losses. For individual traders, the same rule applies.
Lack of Preparation
If you were suiting up for battle would you have a plan? If you were suddenly taken off the bench and told you were going to be in the big playoff game would you condition yourself mentally and physically? Then why do you think trading - a competition in which your own money is on the line - should be treated any differently?
You must prepare each and every day. For me, that preparation starts with physical exercise, which helps to clear your mind of the worries and concerns that preoccupy you. When you're trading you need to give the market your full attention. That means there's no skimping on doing your homework. You can't take a stock "tip" (which may do more to bolster someone else's position than yours) in lieu of doing the research yourself.
As any strategist will tell you, to be successful you must know your
environment. In trading, this means know the "terrain" of the market. What announcements are expected that day - such as the Consumer Price Index or U.S. unemployment statistics - and what are the expectations? Study what the market has done for the past few days. Where are the support and resistance levels?
Risk and Reward Out of Balance
For every $1 lost trading, you must make a minimum of $2.50. That way you can make money even if the majority of your trades are losers. Here's how: Say you lose $100 each on six trades for a total loss of $600. Those losses are kept small with good discipline, trading with strict stops, and so forth. By letting the profitable trades run, you make $250 each on four trades for a profit of $1,000. On a net basis, you've made $400.
Over-Trading
There are days when you feel you can't do anything right. You make a trade - whether it's one S&P contract or 100 shares of Intel - that's a loser, followed by a second trade that's also a loser. Hoping to make up the loss, you double the size of your trade - and lose a third time and a fourth time. · What's happening here? Are your biorhythms out of kilter? Take a break, re-examine the charts, re-evaluate your stops, and take a hard look at the tempo of the market that day. Maybe it's time to sit on the sidelines until the market has a clear direction.
Trading Without Stops
Imagine yourself behind the wheel of a Corvette doing 90 miles an hour with your brake lines cut. That's what it's like to trade without stops. Stops are the brakes that keep you safe in the market. They are the pre-determined points at which you get out of a losing position. Let me stress that again. The pre-determined points.
You set the stop and stick with it. If your stop is hit and you get out of your position - known as getting "stopped out" - it doesn't matter if the market then rallies and you miss the move. Disciplined traders last a lot longer than those who drive the market with no brakes.
Averaging
You buy a stock at, say, $50. It falls to $45. You buy some more. It falls to $40. You buy some more. And so on, until you're at $35 or so and the market finally rallies and you set out at $55. There's actually few "sins" in this scenario, including the failure to use stops and a risk-reward imbalance.
More importantly, averaging has the potential to expose too much of your capital at once. If you keep buying in a falling market, there is the risk that you may spend all your money before you realize it.
In plain words, never move your stop unless your capitalization allows it. Moving a stop automatically exposes you to more risk and a potentially bigger loss. It's not a desperate move, but a strategic one.
Hurting the Integrity of the Market
Of all the transgressions, this is most serious, I believe. No matter how any of us perform, regardless of whether we go home flush or flat, the integrity of the market must be protected. That includes by the exchanges, the clearing firms and the individual traders.
The most egregious of this kind of sin is "taking a shot," meaning, putting on a larger trade than you are capitalized to make. Among the "take the shot" myths is this scenario: You put on an unauthorized trade - say 1,000 T-bonds or S&P futures contracts or 50,000 shares of a stock - and no one at the brokerage house or clearing firm questions the trade. To protect themselves, many clearing firms have instituted "take a shot rules." Simply put, if someone "takes a shot," proceeds from the winners belong 100% to the clearing firm and not the under-capitalized trader. After all, if that trade is a loser, the clearing firm is responsible.
On a less dramatic level, another way to protect the market's integrity is to take responsibility for your bad trades. When you lose money, there are two ways to react. You can grouse all the way home complaining that it was somebody else's fault. Your broker didn't give you a good fill. Somebody gave you bad advice. You weren't loved enough as a child. You can find a million excuses and several hundred people to blame.
Or you can say to yourself, "You know what? I made a wrong decision." You look at the list of Deadly Sins and you do your share of penance. Then you learn from your mistakes and wait for the market to open the next day. |
