Wednesday, October 11, 2006

Trading Do's and Don'ts

Anyone could become a better trader just by becoming or remaining aware of some simple but important "do's" and "don'ts." Markets trade on emotion so if we can learn how to play emotion or group psychology without being ruled by our own emotions, we increase our chances to become better traders. Over the past several weeks, I have written a number of pieces that talk about various factors in trading from money management to trading trends. Each of these little articles have one thing in common and that is the attempt to remove emotion from trading. If we can do that ourselves and, at the same time, develop an awareness of how the group behaves we have given ourselves a leg up on the crowd.

At the risk of being redundant since I have spoken of many of the same things in earlier articles, I want to reinforce some of the principles that I think can lead to better trading.

Some Don'ts

  • Don't trade more than you can afford to lose. The "bet it all on red" theory could yield a huge profit, but more than likely over the long run, it will lead to bankruptcy.

  • Don't enter a position without a predetermined exit in case the play turns against you. When someone buys a stock and it drops, the tendency is to believe that "it'll come back." It may, or it may not. Remember, though, if a stock drops 50% it has to increase 100% just to get back to even. The saying is that "the first loss is the best loss." Why? Because the average trader holds on too long when a play goes against him. Instead of having a predetermined exit, he waits for it to come back or waits for it to come part way back until ultimately he sells in frustration (and that's often near the bottom). Meanwhile, he is wasting opportunity and time.

  • Don't exit prematurely if the move is going in your direction. Just because there is a good profit doesn't mean that the stock can't go higher. Instead of selling during a good move, consider trailing a stop loss order, or use a violation of a moving average or a trend line as an exit.

  • Don't let emotion rule your trading. Learn how to enter and exit at points that are determined by preset rules. For example, some advocate exiting a position when there is a 5% or an 8% loss. If you have a plan in advance - and follow it - you can help remove the emotion.

  • Don't be impatient. So often people subscribe to an advisory service and think it is their way to get rich quick. Truth is, that isn't usually the way it works. Knowledge of risk, risk to reward, knowledge of strategies, money management, and following a carefully devised plan are essentials to getting rich steady, but even then, are no guarantees. Successful trading and investing requires work and time.

  • Don't enter a trade unless you fully understand and appreciate the risks.

    Some Do's

  • Do learn as much as possible about trading and trading strategies. Knowledge is, indeed, power.

  • Do have a money management plan in place and follow it. In an earlier article, I discussed in depth the importance of money management and some ways to manage trading money. Check that article out if you get a chance. I think money management is critically important to success.

  • Have reasonable expectations. Sure, a given trade can yield 35% or 150% in a month, but that doesn't mean you're going to make that rate annualized (420% or 1800% a year). Can it be done? Of course it could be done, but is that a reasonable expectation? Probably not.

  • Do make your own decisions. No one cares as much about your money as you do. No one. Apply your own knowledge, gain knowledge, use your common sense and don't blindly follow others.

  • Do understand how much is at risk in each trade and compare that to the potential reward when you make the judgment to enter that particular trade or not.

  • Remember that the first exit is generally the best exit when a trade goes against you.

  • Listen to those who are profitable traders and don't listen to "Uncle Louie" who probably hasn't had a profitable trade since 1999.

  • Treat trading and investment as a business. In the next week or so, I'll be writing about the business plan and a way to implement a plan.

    Bill Kraft, Editor
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  • 1 comment:

    Manish Chauhan said...

    Excellent Post ...

    Just by applying these simple rules ,onc can surely become a better traders .