The Three Most Common Trading Traps and How to Overcome Them

When approaching the markets, many participants start off with an unrealistic belief about their own ability and set lofty expectations. The outcome from the market is often very different from these initial expectations. These expectations are often provided by the media or people not associated with any actual trading or investing in the stock market itself.

“Most investors believe that markets are living entities that create victims. If you believe that statement, then it is true for you. But markets do not create victims; investors turn themselves into victims. Each trader controls his or her own destiny. No trader will find success without understanding this important principle at least subconsciously.” Van Tharp

This article will outline three of the most common trading traps and how you can develop a ‘rule based trading plan’ in order to remove the emotions from trading.

Trading account failure in a majority of cases can be attributed to 1 of 3 main causes.

1. Poor market knowledge is just a case of poor research.

When deciding to get involved in the market for the first time, traders/investors often neglect to conduct thorough research in order to make informed decisions.

In order to set a solid foundation when it comes to trading your preferred markets, here are a number of key elements you need to take into account.

• Understand the market opening and closing hours of the exchange or instruments you are trading.
• Each market can have different match out rules or opening and closing auctions. You need to understand these differences.
• Make sure you are aware of the contract size you are trading for each instrument. An Aussie SPI futures contract moves at $25 per point. On the other hand, a CFD on the Aussie 200 Index moves as little as $1 per point.
• If you are trading the stocks or CFDs on the stocks, it is handy to know how much your position is moving per cent. If you have 1,000 shares, then each cent movement is worth $10 and so on.
• If you are trading options contracts, you need to be aware of the opening and closing times, expiry dates, strike prices plus many other elements.
• FX markets can be subject to announcements, which can result in considerable volatility. As the FX market is highly leveraged, it can further result in significant movements in the trader’s account both in a positive and negative way.
• Although the FX markets are promoted as 24 hour markets, there is an opening time and closing time over weekends.
• Research the cost of carrying positions, the market hours, the event risk and any potential announcement that may affect the market.

This research and the information gained must be part of what I like to refer to as a ‘rule based trading system’.

2. Improper position sizing or using maximum margin can result in maximum loss.

“The market will let you do anything you like if you have the money.”

When building your set of trading rules, your position size rules should include information from the size of the trading account to the perceived possible market movement- both expected and unexpected.

Unexpected volatility will quickly undo over leveraged trading accounts.

Moreover, it will create emotional pressure on the trader to make decisions when losses are mounting or even when they are presented with an outlier profit. For many, the decision process can often overrule any common sense, thus allowing profits to slip away to a trading loss.

Decisions made under emotional pressure are often illogical and dangerous, because in these situations the trader’s judgement is clouded by stress, both good and bad.

“It is often said: trading should be boring, if trading is exciting-may be your position size is too big.”

A sensible rule based trading system is built around the size of each position and the use of margin.

These are not variables based on some form of discretion, but rather predetermined values inside your rule based trading system.

Position size should be relative to the market, not only the account size but also the market volatility.

Calculating volatility risk using the ATR indicator

A very simple method of gauging current market volatility is by taking notice of the Average True Range (ATR) indicator. For short term traders, you may want to use the ATR over a 2-day period.

For example, let’s say the ATR (2) of the position we are trading is 26 cents and the stock price is $5.60.

Volatility risk is therefore $0.26c / $5.60 = .0464 X 100 = 4.64% for 2 days

Because the Average True Range (ATR) is calculated on absolute values of price, it becomes a very good tool to measure short term price movement as risk.

Let’s have a look at a popular concept by Van Tharp, which is R Multiples

R multiples basically let us express our win and losses in terms of R.

R = Risk.

Reward therefore can be expressed as a number of R.

If, when we go to place a trade, we are risking $200, then 1 lot of risk is $200. We would then say I have 1R risk on each trade. If a trade goes on to make a $400 profit, we would express that win in terms of R, saying we had a 2R win or 2x$200 = $400.

If the trade turned over and hit our stop loss and we lost $200, we’d say we lost 1R on the trade.

Use the calculation below to identify what your risk is as a % of your trading account.

Risk management of your trading account

My capital is $
My position size is $XXXXX
As a % of my account, my position size is XX%
R = Risk
The stop (1R) = $XXX
As a % of account, I am risking = XX%

3. Poor money management when in the trade.

One of the critical keys to long term trading success is to be able to manage your open positions well. The rules around managing your open trading when it comes to money management plays a big part of your overall rule based trading system.

This is where the rubber hits the road, now that the trader has some understanding about the market and position sizing.

Management of the trade firstly comes from the type of trader holding the position.

Are you trading over the short term or longer term?

Short term traders are often holding positions from a few minutes to a few hours or days. Looking for short term moves can be rewarding and time consuming at the same time. With this type of trading plan, the position is often stopped on short notice.

Poor money management will show up when positions are not ended according to the rule based trading plan being implemented.

These discretionary decisions now result in 2 or 3 trading Ideas operating at the same time on the same position. Confusion can set in quickly in this situation.

Money management of a position is letting the rule based trading plan do the work and believing in the numbers of your trading system.

Longer term traders are more comfortable and willing to hold a position to see if a trend continues. There are times during these extended price moves that markets move erratically.

Day to day news may affect the short term movement of price.

When broader markets are waiting for economic news, they tend to become listless and form consolidation periods, prior to the next major move.

“Money management of a trading position has the predetermined entry and exit level set before the trade is taken.”

Management of the trade is the key to trading and investing in order to survive and thrive in the markets.

Let your rule based trading strategy guide your decisions

Using rules without discretion will remove some of the short comings if you are an inconsistent trader. It will remove emotional decision making, allow measurement, deliver consistent results and allow tweaks.

The pathway to finding a method can be as hard as you make it. There are many trials and experiments along the way. The temptation is to look for a particular indicator or a set of optimised moving averages and back test these over past data. The problem with this is that the market is constantly changing.

Don’t succumb to curve fitting

Many new traders fall into the trap of curve fitting. They fit the perfect indicators to match historical market information in order to generate perfect buy and sell signals.

There is no doubt that many indicators work at certain times. However, novice traders often pile many of these indicators onto their screens. This complicates the picture and hinders decision making. The process often ends in curve fitting the indicators to suit the back-tested timeframe, leading to spectacular results on paper (i.e. curve fitted).

Traders become so caught up with the different messages that they forget the most important thing – what price is actually doing.

Survive the initial learning curve and building a strategy that is right for you

Trading can be as hard or as easy as you make it. The reality is that traders just need to survive the learning curve to get an understanding of what works for them and how to approach the market.

Along the way you will make mistakes, which is inevitable. It is rather sobering, but this is all part of the learning curve.

Successful and improved traders prove that you can be successful in the market if you learn from your mistakes.

I hope this article has identified some common traps and prepares you better for your journey. Use your mistakes in your own self advancement to trading success.

Learn more from traders and educators. Subscribe Now!