The main reason for losses incurred on spread bets is trader error. To make sure you don’t make these mistakes, you need to know what they are.
The vast majority of short-term traders lose money over time. But there’s nothing inevitable about ending up out of pocket when you trade financial markets this way. With a disciplined approach and an awareness of the most common pitfalls, you can become a profitable spread-bettor. To help you on your way, here are some of the most frequent errors traders make. Make a note of them and try and avoid committing them yourself.
- Moving your stop-loss further away
Let’s say you do a buy trade on a share at 100p in expectation of an increase to 115p. At the moment that you open your position, you determine the right place for a stop-loss is at 95p. Within a week, however, the price has moved against you, falling to 95.5p.
Despite the drop, you tell yourself that you should stay in the trade. Rather than get proven wrong, you convince yourself that the share will go up before long and that you should therefore hang on in there. That way, you might still make a profit, or at the very least break even. You therefore move your stop-loss to 90p.
Instead of reversing its losses and heading back towards your entry level of 100p, however, the share just keeps on going downwards. Before you know it, the price is at 90.5p, just above your new stop-loss level. Still unable to accept the indignity of defeat, you shift the stop order again to 85p. This sequence continues until you finally recognise the futility of what you’re doing.
The lesson here is simple. Choose a stop-loss based on appropriate chart levels. Then abide by your decision. If the stop is triggered, accept it and move on. Your trade idea didn’t pay off , but so what? Much better to get out early for a small loss than to hang on until you can no longer take the pain.
- Abusing leverage
Leverage is a powerful tool. Using borrowed money allows you to control a position worth many times more than the funds in your trading account. Levering yourself up ten times can turn a 10 per cent market move into a 100 per cent profit – or loss, if you’re wrong about its direction.
Say you’ve got £1000 spare that you decide you can commit to trading. You open a £5-a-point position on the FTSE. If the FTSE is at 4000, the value of your position is £20,000. If the index moves 200 points against you – a mere 5 per cent change – your £1000 will be entirely wiped out.
The key here is only to take positions that you can comfortably afford. Risking your entire trading pot on a single trade would be totally irresponsible. If you’ve only £1000 to spare on trading, you should take positions at the smallest available size.
- Taking profits too soon
There’s an old investment saying that you should ‘let your profits run and your cut losses short.’ In practice, though, many traders do exactly opposite. When things go against them, they move their stop-loss and go even further underwater on their position. And, at the first hint of a profit, they close their position and bank their gain.
While quitting while you’re ahead is usually a sound principle, it is important not to jump the gun. Trends in financial markets – both up and down – often continue for much longer than most people initially expected. This is is just as true for bull and bear markets lasting many years as it is for moves over a couple of weeks.
Say you do a sell trade on an asset at 100p, which promptly then drops to 95p. Gratified by your instant success, you close your position, taking a small profit. But the asset continues to fall thereafter, tumbling to 85p within just a few days. You are left kicking yourself at your decision to get out when you did.
Your decision to exit a profitable trade should always be informed by what your latest research tells you. If you use charts and the asset you are short-selling is not yet oversold and there are no support levels at hand to break its fall, there is a good case for remaining in the position. To protect your profits, you can bring your stop-loss order closer to today’s price. Seek opportunities where the potential profit is at least three times the distance to your stop loss.
- Trading on impulse
Trading is exciting and can be extremely profitable. Sitting on the sidelines is dull and doesn’t make you any money. As a result, you may feel you have to be in the market at all times, forever opening and closing positions. If so, you will probably open and close positions for completely random reasons, rather than following any coherent game-plan or rules.
The desire to be in the market at all times can become especially strong when you’ve had a string of successful trades. Having several winners in a row can easily end up going to your head. You begin to believe you have second-sight and start to try and anticipate moves, rather than simply following existing ones. Overconfidence takes over and your golden touch disappears.
Impulse-trading can also be a problem when you’ve had a series of stinkers. Quite simply, you want to make back the money you’ve lost and prove to yourself that you’re a decent trader after all. Needless to say, entering trades with this mindset is a sure-fi re way of ensuring you stay on skid-row until you come to your senses again.
To avoid impulse trading, work out a rules-based approach to your spread-betting. Back-test your methods to check how well they did in the past. Only enter the market when your conditions are met. Never worry about missing the boat and accept that waiting on the sidelines is a vital part of the game.
- Trading too many markets
There are literally hundreds of different markets and assets that you can trade via spread bets these days. For some traders, all this choice can be just too tempting. Enthusiastic newcomers often fall into the trap of trying every jar in the sweet-shop: they open positions in loads of different markets just because they can.
As a lone private trader, keeping track of numerous markets at the same time can be a major struggle. To trade a market effectively, you need to follow not just its price action, but understand what makes it move and what its quirks are. The best traders get to know the assets they trade intimately. They follow their movements intensely and they know what other markets have an impact on them.
Concentrate on a handful of markets that interest you or where you feel you have an edge. Get to know their ins and outs and manage your orders accordingly.
- Ignoring fundamentals
For short-term speculation, price-charts are the best source of trading ideas. Momentum and sentiment matter far more over brief periods than fundamental factors like valuation. But this is not the same as saying that fundamental factors can be disregarded entirely. News events can have a significant impact on the success or failure of your positions.
Of course, many news events are by nature surprises. It’s very hard to anticipate certain types of shocks. However, many pieces of newsflow are also scheduled, such as the release of economic data or company profits. While you may not be able to know what exactly they’re going to contain, it is worth knowing when they are due out and what their significance is.
A common mistake is to enter a position just prior to a big news release. For example, you might buy the US dollar and sell pounds just before crucial American employment data is announced. If you know the release is coming and have an insight into what it might bring, taking a position may well be logical. Frequently, though, private traders aren’t even aware the announcement is pending, let alone its significance.
Always be aware of the regular events that can move the particular markets you trade. Check the calendar of forthcoming economic and corporate releases that appear in the financial press. Do not enter positions just in advance of them, unless you have a particularly strong view about their likely impact.
- Replacing conventional investing with trading
Trading the markets with spread bets can be hugely rewarding, both as a pastime and as money-maker. At the same time, though, it is not meant to take the place of your conventional investment activities. Returns of several hundred percent on a single trade within hours or days are much more than you could ever hope to achieve with buy-and-hold investing, this does not mean you should switch exclusively into trading.
Over the long term, buying and holding shares, commodities and other assets is best done through conventional holdings. This enables you to enjoy the full benefit of reinvesting dividend and bond-income, which is the most important ingredient in returns over your lifetime.
Consider trading as a lucrative sideline to your mainstream investment activities. The vast majority of your funds should be in shares, real estate, bonds or whatever you have worked out with your financial planner. Only trade with money you have spare and can afford to lose. At the end of the day, it’s a risky pastime.
[This article is brought to you courtesy of Selftrade]