How to Lose Money When Trading: A Trader is Born
The idea of these articles is not to make you the ultimate trading machine. Only few are and will ever be. The idea and intention here is to help you avoid the most common mistakes that either make you lose some or all of your savings. In worst case trading may put you into debt. Becoming a winner is very much like evolution in nature - learning by mistakes. The stock market is full of predators just waiting for newbies they can feed on. Stocks may be subject of pump and dump where news are pushed to press the stock up while major players sell, or the other way around. Some stocks are played where professional traders fire up a rally which in most cases make small traders lose as they get in too late and get out even later. Lack of knowledge and access to information is also a major pitfall for most of the minor traders.
I will bit by bit introduce technical analysis in this text as I believe this is a tool any trader should know. Technical Analysis (TA) will help to improve your timing and ultimately help you make better overall trading decisions. In the end it all comes down to decisions, and in the stock market there is very little room for error unless you have proper stop-loss strategies.
Chapter 1 - A trader is born
Getting into stock trading is easy
Most new traders start because somebody is telling how easy it is to make money in this market. It may be a class friend, a news article or an “expert” advice on TV or radio. Usually most new traders enter markets in the late stages of a long upturn when newspapers start to write how much you could have made if you played the markets. To me the ultimate sell signal has always been when “trading and stocks” appear in the knitting magazines.
Lately the Bitcoin and other crypto currencies have been booming. Some people have been lucky as they were hitting the uptrend. Their profit was caused not because of the insight or skills, but by pure luck being at the right place at the right time. Because of this, tons of “experts” appear. They can explain and assure that the only way for cryptocurrencies is up. The fact is that a true “expert” have been in volatile markets or even seen the dreadful bear-market where people lose their homes, businesses are going bankrupt and fortunes are lost overnight. These are very hard lessons, but the best of the best make even more money in falling markets.
Since most traders enter market looking for the easy money promised, the disappointment is huge when first losses are a fact. There are always many excuses for the losses, but in most cases, everybody blames others and not themselves. From this point and forward in your trading there is no excuses. You and only you are the one making decisions. If you manage to accept this simple yet powerful fact, you will be ready to move on and become a better trader. It is all about decisions, whether it is investing into a fund where professionals handle your money, or if it is day trading.
Take responsibility for your actions and learn from them.
Accepting the facts
Nature is cruel, it is not soft like humans. It doesn’t spare the weak and only the strongest survive. Nature is as close to perfection as it is possible to get to, and it has taken billions of years to achieve it. To make you a “perfect” trader in 5 minutes or 2 months is wishful thinking, but while nature learned it the hard way, step by step, humans can learn from history and each other.
Given the fact that nature doesn't have options like humans have, it is per definition easier for the nature. Nature is a beautiful 0 or 1 algorithm. Nature is the divine script all programmers dream to create. In fact, as a trader you should strive to become more like nature is. Weak stocks do not belong in your portfolio. Weak decisions should not exist. Words like “maybe” should not be in your vocabulary. There is no such thing as “maybe a good buy” or “maybe I should sell”. Having a weak stock, making a weak decision or having a "maybe" in your vocabulary is a guaranteed way to lose money.
Some long timers may tell stories about stocks doing marvelous turnarounds. Yes, even I have sold stocks just to see them re-bounce to the sky. However, most people fail to see is that for every 1 stock doing it, 9 will fail. In trading you want to be more than 50% correct. This is where you’re making money. Not by being lucky.
But let us jump back for a second. I started by saying that most traders enter the market in the late stages of an up-trend when even the knitting magazines are recommending stocks. I then said that your first decision is to be responsible for your actions and you are the only person to blame. Furthermore, I said that as a trader you should strive to become more like nature. I pointed out that weakness will make you lose money. If you have invested in stocks or Bitcoin you need to understand that you’re in the predator’s market, and only the strongest will survive. I will now try to give examples for the first two parts of this text before moving on.
Know where you’re from to know where you’re going to.
You have entered the market and you are making trades. But do you really know anything about the market you have entered. Do you know what part of market cycle you are in? In the beginning of a bull market you can put your money on almost anything and hit bulls eye. Crypto currencies are the most recent example of this. But at the end it is almost impossible to win, and losses will be more common than profit. Everything moves in cycles, short, medium and long term, and bear markets have been as certain as bull markets. If you are totally new to trading; bear market is a falling market while bull market is a rising market. All you really need to know is that whatever goes up, in most cases comes down. There is plenty of Bitcoin owners that have seen a super profit on paper being reduced by 50% in less than 1 month (Dec 2017 Bitcoin fell from USD 19.900 to USD 10.000 in just a week).
If you understand at what part of the cycle you have entered the market it is easier to make good decisions and understand why good trades go bad. Anyone entering the US stock market now is entering a market that is overbought on short to medium term. In fact, the market is now defying gravity which will just make the fall harder. In euphoric markets volatility is high and stocks behave erratically - with strong gains and strong falls, often within the same day. For a very disciplined trader it is perfect market, but for most it is a rollercoaster ending with huge losses.
Below is the chart of the Nasdaq index as it is right now when these articles are being written (Jan 2018). The red coloring in the line at the end indicates that the index is overbought on the relative strength index. (RSI). [ RSI will be introduced in more detail later. ] But for simplicity just imagine there is 100 available traders. When more than 70% is positive you should be warned that too many is positive and at Stockinvest.us we color our charts red when RSI passes 70%. And green when it falls below 30. The logic is that when everyone is positive the next person will be negative. At the very end of overbought all credit cards are maxed out and all is in. There are simply no more buyers to push it further up.
Any investment made now have higher risk than investments made in the beginning of 2017. And extremely riskier than investments made in 2011. This does not mean you should not invest, it just tells you that you need to treat your trades differently. “Personally, I have more than 50% of my trades invested in shorts, which is a bet that market will fall. I also keep a higher stop-loss on my stocks due to the high volatility. My trading horizon is also way shorter as I don’t want to get stuck in bad positions. I avoid investment into ill-liquid stocks as these can fall drastically from one day to the other. Neither do I sit 100% in market overnight or weekend. I always keep some cash available so am I ready to act on good trades. It also lowers my general risk.“
To give a better understanding why it is important to know what part of market cycle you have entered, it is better to look at the Nasdaq history in a longer perspective.
By looking at everything in perspective it is easy to imagine that the next step ahead will probabaly be a fall. But remember that “experts” promised a huge stock fall back in 2015, and for sure when Mr. Trump won the election. I have still to see a perfect algorithm or a perfect “expert” with perfect timing. The Nasdaq exchange may easily go up to 10.000 points because at this stage anything can happen, and it will happen fast. Up as well as down. This is the volatile part of the market cycle which is perfect for the disciplined trader.
If we look at the Bitcoin chart the huge fall lately is almost logical, and I am not sure the worst part is over yet. The reason for this is the lack of real support before USD 5.000 range. But that is another discussion.
To sum up, you are responsible for your decisions. You need to know where in the cycle you are in all trades and all markets. This will put you on top of the situation, and not leave you in darkness. I have said, it is a predator’s market, but not explained it in detail, for we will get to all that in a minute. If you still believe others are to blame for your trades, then you have just wasted your time reading all this. In the next part I will be looking at some basics.
If you hesitate you will be eaten alive.
Start with getting a proper broker
As earlier mentioned most new traders get late into the game and are usually driven by a desire to join the train to riches. In many cases establishing the trading account is done on impulse without doing proper homework first. Often it is done by following a link from a web commercial or by referrals from a friend. Setting up a trading account is easy, and first trades are often done without even knowing exactly what was done. Getting an account usually requires some online forms, copy of a certificate and then adding some cash to the account. Once the account is established a blue or green button will let you buy. With a single click you’re in the game and instantly you have affected your future. I don’t know how many people have approached me after losing huge amounts of their savings, but they have all done the classic mistakes. I am no exception.
There is a huge variety of brokers out there. As beginner or even as a professional you should always seek brokers that offer you to trade directly from the exchange trading books (broker is directly connected to the main exchange). This will make sure you are trading on the actual market price and can take advantage of the full trading range (also known as spread or difference between highs and lows). This is very important, especially if you are day trading. When day trading - minutes and often seconds matter. You do not want a broker that provides delayed prices. You want to get in and out of trades in real time.
Other important thing is to keep in mind that the fees are related to trading. At serious brokers you should be able to do a USD 20.000 trade for as little as USD 2-3 in total fees. Some brokers will tell you that you can trade for as little as USD 0.50, but what they fail to mention in the headlines, keeping in small notes at the bottom, is that you’re not getting market price on your trade. It is a huge difference buying for instance Apple @ USD 177,50 and USD 178.20. The USD 0.70 difference may in many cases be the entire spread of the day.
In these modern days you would prefer to use an online broker that offers trading on both from web and from application. In many countries proper online brokers derive from banks or well-known trading houses. Most banks do offer trading from your bank account, but often with bad interface, high fees and lousy market coverage (number of shares you can trade). Ideally you want a broker that offers several markets to get a better population to trade from. There is for instance only a few hundred companies listed on the Oslo Stock Exchange (OSE), while there almost 2.800 stocks on New York Stock Exchange (NYSE).
As a foreigner you can, with some hassle, get a trading account at the American broker TD Amitrade. Once your account is established you can enjoy the lowest fees and most accurate market prices for the US market. The point is, that in the end this will allow you to make money on even 1% day spread. And this is where the money is.
It is better to spend a day extra doing things properly, than regretting for years
Try to stay away from CFDs until you are ready
In most cases beginners join a CFD broker (Contracts For Difference) and while it looks like they are trading real stocks - they are not. CFD brokers offer margined contracts on financial products (stocks, currencies, cryptos etc.) and according to a recent article 74% of all CFD traders lose money. This is the main reason why it is so important to understand what type of broker you get and being able to compare this broker to alternatives.
Some will argue that CFD brokers are very good as they offer leverage (trading where you only put in a small amount of the total trade and therefore allow small investments to take large positions). For example, you can put in USD 150 and the CFD broker will put in 20x, making your USD 150 investment worth USD 3.000. But there is no free lunch in the stock market, and for sure not in the world of CFDs. Usually it will take some losses to understand.
When it comes to CFDs the very first trap is the high spread between sell and buy. The second trap is the deviation from actual trading price for the security (at the exchange where stock is listed). Let us take a real example. Imagine you want to buy Apple [AAPL] and that it is traded for USD 178,25 at Nasdaq stock exchange. You, however, are using your CFD broker. In most cases the CFD broker will do two things:
A) It will give you a very bad spread meaning it will be a huge difference between buy and sell price. In the case of AAPL the CFD company will offer you to buy AAPL for USD 178.64 and sell it for USD 178.25. In this case the spread is USD 0.39 or 0.22% between by and sell, which is far higher than at the actual exchange. In simpler words it means that AAPL will need to rise 0.22% before you are at breaking it even.
You may think this is not so bad, but in most cases the spread is larger and there may be a transaction fee involved. If you decide to keep position overnight you will be subject to more fees.
A forced leverage, in this case 1:20, meaning that you put up money for 1 stock and the CFD will lend you the cash for 20 more. For USD 1.000 you can hold AAPL stocks for USD 20.000. This may sound very good as you get more exposure, but unless you have enough cash to cover sudden changes it will keep you in an unwanted leash.
To make it worse most CFD companies also lag the price in the wanted direction. If stock goes up - the price at the CFD broker moves up slower, but instantly kick in on price drop. This means you will never be able to get optimal trades hitting the exact bottom or top. I have seen the difference in lag reducing an actual trading range (bottom – top) of 7% on the exchange to be only 3.5% at the CFD broker. This simply means that you could lose 50% of the potential profit. I assure you that they will increase your loss if they can. The reason is very simple. While at proper brokers you actual buy a share, you only buy a contract for a share at CFDs. So it is in their interest that you lose as your money then will go straight into their pockets.
b) The other major thing CFD companies do, and especially for currency pairs, is flushing positions. Huge algorithms keep track of how many positions can be closed by pushing or dumping prices. To avoid legal conflicts the buyers and sellers are not associated with the actual companies, but the money derive from the same sources. There is the reason why most of the CFD companies are registered at Malta or similar countries. It is all about mathematics. If a position is closed, you lose your investment. If closing your position costs less than what can be gained, it will always be lucrative. This game which is played by all major players is known as pump and dump and comes in all varieties in any kind of financial instrument. Very often these actions are followed up by news to increase the effect. The market is indeed for predators and this should always be in the back of your head. Personally, I love to pray on pump and dump as these can easily be detected and the pattern is very predictable.
You may ask why I don’t recommend avoiding CFDs totally. The answer to this question is in the huge leverage they offer. If you are willing to pay the price and know the risks, then CFDs is a way to access more capital for your trading. Nevertheless, CFD broker should never be your main trading source.
A good start is everything
Chapter 2 – Stock picking
Choosing the right stock to buy/sell
I hate the word random. It includes too much uncertainty for me. But the fact is, that in a very strong bull market you can just do a random choice and in many cases, be better off than listening to a professional. In strong bull markets, the professionals usually underperform compared to the index. In bear markets the situation is totally different. You will need both skills and luck. There is a reason why one of the most famous expressions is “let the trend be your friend”. Therefore, it is so important to understand “where you are” when you enter the market, and for sure when you enter the “stock”.
And now it starts to get a bit more complicated, because your picking strategy should be based on several factors, and these will change every day. It is obvious that in bull markets (rising markets) you can allow yourself higher risks, while you must limit your risk in bear markets. Not so obvious is the different interpretation of volume in bear and bull markets which is vital to determining a good entrance and exit point in a stock. But if you understand that in a bull market liquidity is flowing into the markets, the opposite is happening in bear markets. People would seek other and safer investments or simply put their money in the bank. In a bear market less volume can affect the stock price even more.
So how to pick a stock?
You don’t, you let the stock be picked for you.
If you’re a good trader you have good strategies, and these strategies pick the stock(s) for you. By following a strategy, you will also be able to identify mistakes and learn from them (nature).
Creating a strategy is a lot easier than you think, but it takes time to create a good one. A good strategy is shaped around your personality and trading capital. If the strategy is not aligned with your personality it will be extremely hard to follow it. If your God is Elon Musk, and Tesla is your dream car, you will never be able to sell or buy Tesla (TSLA) when you should. If you are not patient, you should never get involved into ill-liquid stocks. If you have limited capital, you should avoid CFDs as nobody can predict the market accurately. Only Kim Jong-Un takes 1 minute to crash all markets in the world.
Defining a strategy - the start
Defining and making a strategy is not something to be learned in 5 minutes, but I will keep it very simple. The first question you should ask yourself is: “how much money do I have?”. The second question should be: “how much of it can I lose?”
Earlier I told you there is 2.800 stocks at NYSE. If answer to questions 1 is that you have USD 1.000 to trade for you should only trade 1 stock at a time. If you play more than 1 stock at the time you will need higher return on each stock to cover trading fees. If you got USD 10.000 the answer is different. If you cannot lose more than 20% of your capital, there will no longer be 2.800 shares for you @ NYSE. You will have to remove all penny stocks (stocks under a dollar) since these are too volatile and unpredictable. You will also have to remove all other stocks that are considered high risk (risk can be defined by some different parameters and we will get to it later). After these few changes there will be only like 500 out 2.800 stocks left for you. Still there is no 100% guarantee that you will not lose 20%, but you have reduced the risk according to your strategy. If it is a bull market, most of the stocks can be a good pick, but if it is a bear market - as few as 2 of the 500 will be a good pick.
The two initial questions make your base. The 3’rd question should be: “Do I want high, medium or low risk?” If your answer is high risk, there will only be a few of the 500 stocks that fit your criteria, because you already reduced risk in your first question. There is no penny stocks left or other highly volatile stocks, but there is a major difference between buying Boing (BA) stocks and Walt Disney Company (DIS) from both a technical analysis and fundamental point of view. One can be considered to have more risk than the other. You can have a guess which one. Later we will get to which parts define the risk and how this can be seen in the chart.
So far we have defined 3 points forming your strategy and identified how this would have reduced the number of stocks to pick on NYSE from 2.800 stocks to less than 500. By now a strategy can be vocalized:
“I will invest USD 1.000 for trading at NYSE. I will cut my losses @ USD 800 and not invest into penny stocks or stocks with extreme volatility. I will invest in 1 stock at the time and for all stocks passing my first criteria I will select stocks with higher risk”.
This is by no means a very well-defined strategy but is far better than random stock picking. It will also make many decisions for you. If you lose 20% of your capital you are out. You will not attempt to re-gain by investing more or with higher risk. You will neither sit in 3 stocks paying for example USD 15 in fees, but instead in one stock paying USD 5. The difference is 1.5% profit and the other is only 0.5%.
If you got USD 10.000 the situation is a bit different. The amount of cash will allow you to work your risk differently. While being in only 1 stock at the time everything falls and rises within the 1 stock, but if you have 3 stocks it is different. In the case of 3 stocks it is enough that 1 stock gets strong gains and the others don’t collapse. It is simply a different ball game.
Since strategy reduces the amount of stocks you can select from, it will also be easier to pinpoint what went wrong if your trading does not yield. When you have been trading for some time you will realize that not only stocks, but also whole sectors move differently. One sector may for instance go down or underperform in a strong bull market. This may usually be affected by fundamental news like falling oil prices or some regulations. If you work by your strategy, but keep picking stocks from the underperforming sector, you may end up losing money. Your first idea will then be that trading by strategy is just bullshit. But what your strategy needs is to be tuned. If you have some cash you can easily avoid this trap by having a rule that you will never have 2 stocks in the same sector. Personally I like to add one of the most important factors in stock trading;
- Know your fundamentals.
To be continued...
Co-founder @ StockInvest.us