Masters Series: Do You Make This Major Trading Mistake?
Editor's note: It's a simple idea.
But understanding it – and putting it to use – separates novices from experienced traders.
In today's Masters Series essay – adapted from a January issue of DailyWealth Trader – Ben Morris discusses this idea... and explains how to make sure you aren't making this huge mistake...
Do You Make This Major Trading Mistake?
It's one of the simplest ideas traders get wrong...
Over, and over, and over again.
If you don't understand this idea, you are destined for a lifetime of frustration in the markets. But once you learn it, you're on your way to pulling regular profits out of the markets.
The idea: Plan the trade. And trade the plan.
"Planning the trade" means figuring out your upside potential, defining your exit strategy, and calculating your position size.
If you don't do this, there's no way to define success. Despite what lots of folks think, a profitable trade isn't always a successful trade. And a losing trade isn't necessarily a bad one. Sophisticated traders know that a successful trade is one for which you have a good plan... and you stick to it. Win or lose.
You see, over your trading career, you'll form, use, and refine lots of different trading plans. You'll get better at estimating your upside potential, setting your exit strategy, and matching your position size to your personality. (For example, if you're not good at handling volatility, you can use smaller position sizes on volatile stocks.)
If you don't start every trade with a plan, you'll never learn what works for you and what doesn't. You'll never improve your trading. So you must plan your trades.
The second part of today's idea, "trading the plan," is the part that even market professionals struggle with. And it's where the biggest, most frequent mistakes come into play.
Trading the plan means sticking to your exit strategy. For newer readers, I'm talking about using stop losses.
A stop loss is a predetermined point at which you'll sell a trading position if it reaches a certain level... no questions asked. They are designed to limit trading risk and to remove emotions from the trading decision.
There are lots of different ways to choose a stop loss... But two of the most common – which I like to use in DailyWealth Trader – are "trailing stops" and "hard stops."
A trailing stop is calculated as a percentage below a stock's highest recent price. For example, let's say you buy a stock at $10 per share and use a 15% trailing stop. When you enter the trade, your stop price is $8.50 (15% below your purchase price). But if the stock rises to $20, you sell the stock if it falls to $17 (15% below its high while you've held shares).
The beauty of trailing stop losses is that they allow you to stay in during the uptrend... while providing a predetermined plan for exiting positions when the trend turns lower.
A hard stop is chosen before entering a trade and remains fixed. You can use either a specific share price (like $8.82) or a percentage below your purchase price. A hard stop gives your trade a lot of "wiggle room" on the upside... But it's not flexible on the downside. So it's unlikely you'll lose much more than you originally decided was acceptable.
Sticking to stop losses is simple in theory... but difficult in practice.
When the market is falling apart and your portfolio is showing big losses, the natural human instinct is to sell a few positions – at any price – to stop the pain.
I've been there. I've done it.
And I've regretted it afterward.
For one, the losses usually feel a lot bigger in the moment than they really are. If you use proper asset allocation, even an awful week for stocks shouldn't represent a large drop in your net worth.
For example, if you have 30% of your money in stocks and your portfolio drops 10%, it feels like a catastrophe. But that's only 3% of your net worth. Sure... It's 3% you'd rather not lose. But it won't destroy your retirement or change your quality of life.
It's not a good reason to sell.
Also, when folks make the decision to sell while the market is dropping, they almost always sell the wrong position. They usually choose a position that has already caused them pain... and that they've been thinking about selling for a while. Then, when they finally do sell, it miraculously rebounds and soars. It was the exact bottom.
This is just how the market works.
These decisions based on emotion instead of logic are rarely a good idea. How can you improve your trading if your "system" is to "sell when it feels bad"?
Keep this in mind during tough markets. Remember to plan the trade... and to trade the plan.
Good trading,
Ben Morris
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