hen 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.