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Trading tips and traps

This article appeared in the March 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Follow these 10 rules to boost profits.

Photo of Dale Gillham By Dale Gillham, Wealth Within

I was once told by a wise person that investing without knowledge is gambling. It was not until I started investing that I understood the essence of this message. Over the years I have learned that gaining knowledge is one thing; gaining the right knowledge is critical.

It has been my experience that when learning to trade, the vast majority of information and education is of little use to most people and hence why so many fail. More importantly, what I found was that once I had gained the knowledge, I wanted to know if I really understood what I had learnt.

People read books and attend seminars to learn how to trade, but in my experience all they get is a little bit of knowledge and little understanding. Let’s face it, would you really trust your money and financial future to a person who has attended a weekend workshop, bought some DVDs or read a few books?

The cold reality is that trading is one of the few things you can do where you know from the outset you will lose money. I have found that while all traders agree with this statement on an intellectual level, the majority never believe it will happen to them. Some people say ignorance is bliss, but in trading, ignorance can be very expensive – and in many cases more expensive than getting a good education.

It is common for those new to trading to trade markets that are high risk, to take on more leverage than they can handle, and to get their information from all the wrong places. Ignorance leads to over-confidence, especially if the person has been successful in other areas of their lives. Over-confidence leads to over-trading, trading short term and making poor decisions based on a perception that the trader is “bullet proof’. Many only find out all this when they lose their money.

The common theme among many traders who fail is that they falsely believed they could get rich quick by using very little money or time. This get-rich-quick idea is perpetuated by many would-be sharemarket educators and their free seminars and DVDs.

Sadly, while it is a romantic idea, it is a fallacy to think a trader can be successful without a proper education, the right skills and experience. The market does not care how much you think you know or that you might only have a few thousand dollars, it just does what it wants to do irrespective of whether you make money or not.

The most common mistakes

Learning to trade is a journey, and after having taught share trading for more than a decade I could write a book on the mistakes traders make. Some of the most common I see include:

  • Failure to set stop-losses or setting them too tight
  • Over-trading
  • Over-use of leverage
  • Poor money management
  • Relying on software to make decisions.

My experience is that the majority who trade the market do so with little knowledge, blissfully unaware of what they do not know until it costs them a lot of money.

A major trap for traders is the tendency to act on emotions rather than logic. This means they don’t trust themselves, their skills or trading plan – which stems from having a low level of knowledge, skill and experience.

The result is traders who act through a fear of losing and end up taking a micro view of the market by watching their trades daily or even intra-day. Worse still, they make their decisions based on short-term market volatility, leading to the even bigger sin of “over trading” as they chase the market to try to regain lost capital or profit.

The fear of losing is amplified when there is little or no strategy in place. Contrary to popular opinion, daily charts only show the short-term movements of the market and I believe they are of limited value to the majority of traders. The use or over-use of daily charts is a major reason why so many over-trade as many more short-term triggers become evident, yet properly assessing the market trend is almost impossible from a daily chart.

The trap of leverage

The next trap is poor use of leverage, which leads unskilled traders to trade on emotion and set stop-losses too tight. This is very evident in those attempting to trade CFDs (contracts for difference), currencies, options and other leveraged instruments. Unless you can trade shares using cash, you should never attempt to trade highly leveraged markets like those.

Ignorance and over-confidence abound in these areas as people often mistakenly believe they can handle the fluctuating extremes that leverage brings. In these markets you could make or lose 100 per cent in hours or minutes, and you need highly developed skills. For most, trading leveraged instruments is like giving the car keys to a 10-year-old.

Successful share trading relies on developing a simple plan and sticking to it. A trading plan must have your buy/sell rules, money management rules including stop-losses, and how you intend to manage the trade. All too often when I ask inexperienced traders what their plan is, they either don’t have one or are very vague.

A good plan is critical to success as a trader, and once it has been developed you need to rigorously test its effectiveness. Trading is not about finding a new indicator or tool that someone says will make you more successful; it is about having a simple plan and following it.

Test every change of plan

I encourage everyone to learn more, but it is important to remember that if you change your trading plan you change its effectiveness, which may not be for the better. Therefore, each time you change a plan you must back-test it. If you don’t you are gambling with your money and increasing the probability that you will join the 90 per cent of share traders who lose.

It may surprise you that I do not trade using common lagging technical indicators such as MACD’s or moving averages. (Editor’s note: the ASX Charting Library has information on common charting terms).

I find that relying on the latest techniques or computer software is of limited value and prefer to use the tried and tested techniques and strategies of masters such as Gann, Elliott and Dow. These techniques are leading indicators and as such they provide more consistent entry and exit signals than lagging indicators.

By using leading indicators I am better placed to “time the market”, which results in more and consistent profits. It requires a little more work in learning how to apply some of these techniques, but you have to ask yourself if you want to trade successfully or not. The effort is well worth it.

Spend more time on exit strategy

One of the biggest challenges for traders is when to sell. Usually they will be armed with many theories on how to pick the best trades to enter the market and spend about 80 per cent of their time trying to find them, but very little time working out when to sell. Asked about exit timing, these people often give a confusing array of examples that are, in most cases, more guesswork than solid theory, or based on the fear of losing profit or capital.

Traders dramatically increase their probability of success if they spend more time working on better managing their trades and exits. Trading for profit is about using sound money management rules and good exit strategies; in essence, following the golden rule of “let your profits run and cut losses short”.

Get stop-loss points right

When setting a stop-loss it needs to be far enough away from your entry price to allow the trade to settle in, but close enough to protect capital. Everyone, regardless of whether they are trading or investing, needs to use a stop-loss or have an exit strategy every time they trade. Not doing so will result in unnecessary risks, lower profits and larger losses.

Various stop-losses can be used depending on what you are trading. For example, the stop-loss I would use for blue chips is different to what I would use for a speculative share or CFD. As a general rule of thumb, I always set my stop-loss at 15 per cent below the purchase price when trading blue chips.

No matter what your goal is, it is essential for longer-term success as a trader to not follow the herd, the 90 per cent of traders who fail, but follow the rules and principles of the successful 10 per cent.

These are my top 10 tips on how to profit from the sharemarket:

  • Don’t dollar-cost average
  • Don’t buy cheap small-caps
  • Don’t buy and hold
  • Don’t over-use leverage
  • Don’t be affected by the herd mentality
  • Use stop-losses to protect capital
  • Buy only top quality shares
  • Always manage your risk
  • Diversify, but not too much
  • Lastly and most importantly, educate yourself!

About the author

Dale Gillham is author of How to beat the managed funds by 20%, and Director/Chief Analyst of Wealth Within.

From ASX

ASX Online Shares Courses are a great way to access free education about share investing. There are 11 courses to complete online, each taking about 10 minutes on average. Topics include:

  • What is a share?
  • Why and how to invest
  • Risks and benefits of shares
  • What to consider in an investment
  • How to buy and sell shares.

The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

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