5 Fatal Flaws of New Traders

06/19/2014 8:00 am EST

Focus: TRADING

Jeffrey Kennedy

Editor, Commodity Junctures and Trader's Classroom

Jeffrey Kennedy of Elliott Wave Junctures discusses the major mistakes that often keep new traders from becoming profitable.

If you've been trading for a long time, you no doubt have felt like a monstrous, invisible hand sometimes reaches into your trading account and takes out money. It doesn't seem to matter how many books you buy, how many seminars you attend, or how many hours you spend analyzing price charts, you just can't seem to prevent that invisible hand from depleting your trading account funds.

That brings us to the question, "Why do traders lose?" Or maybe we should ask, "How do you stop the invisible hand?"

Whether you are a seasoned professional or just thinking about opening your first trading account, the ability to stop the hand is proportional to how well you understand and overcome the five "fatal flaws" of trading. Each fatal flaw represents a finger on the invisible hand that wreaks havoc with your trading account.

Fatal Flaw 1: Lack of Methodology
If you aim to be a consistently successful trader, then you must have a defined trading methodology, which is simply a clear and concise way of looking at markets. Guessing or going by gut instinct won't work over the long run.

If you don't have a defined trading methodology, then you don't have a way to know what constitutes a buy or sell signal. Moreover, you can't even consistently identify the trend correctly.

How to overcome this fatal flaw? Write down your methodology. Define in writing what your analytical tools are, and, more importantly, how you use them.

It doesn't matter whether you use the Wave Principle, point and figure charts, Stochastics, RSI, or a combination of all of the above. What does matter is that you actually take the effort to define it (i.e., what constitutes a buy, a sell, your trailing stop, and instructions on exiting a position).
And the best hint I can give you regarding developing a defined trading methodology is this: If you can't fit it on the back of a business card, it's probably too complicated.

Fatal Flaw 2: Lack of Discipline
 
When you have clearly outlined and identified your trading methodology, then you must have the discipline to follow your system. A lack of discipline in this regard is the second fatal flaw.

If the way you view a price chart or evaluate a potential trade set-up is different from how you did it a month ago, then you have either not identified your methodology, or you lack the discipline to follow the methodology you have identified.

The formula for success is to consistently apply a proven methodology. So the best advice I can give you to overcome a lack of discipline is to define a trading methodology that works best for you and follow it religiously.

NEXT PAGE: Having Unrealistic Expectations

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Fatal Flaw 3: Unrealistic Expectations
Between you and me, nothing makes me angrier than those commercials that say something like, "...$5,000 properly positioned in natural gas can give you returns of over $40,000..." Advertisements like this are a disservice to the financial industry as a whole and end up costing uneducated investors a lot more than $5,000. In addition, they help to create the third fatal flaw: unrealistic expectations.

Yes, it is possible to experience above-average returns trading your own account. However, it's difficult to do it without taking on above-average risk. So, what is a realistic return to shoot for in your first year as a trader; 50%, 100%, 200%? Whoa, let's rein in those unrealistic expectations.

In my opinion, the goal for every trader their first year out should be not to lose money. In other words, shoot for a 0% return your first year. If you can manage that, then in year two, try to beat the Dow or the S&P.

These goals may not be flashy, but they are realistic, and if you can learn to live with them—and achieve them—you will fend off the hand.

Fatal Flaw 4: Lack of Patience
The fourth finger of the invisible hand that robs your trading account is lack of patience. I forget where, but I once read that markets trend only 20% of the time, and from my experience, I would say that this is an accurate statement. So think about it; the other 80% of the time, the markets are not trending in one clear direction.

That may explain why I believe that for any given time frame, there are only two or three really good trading opportunities. For example, if you're a long-term trader, there are typically only two or three compelling, tradable moves in a market during any given year. Similarly, if you are a short-term trader, there are only two or three high-quality trade set-ups in a given week.

All too often, because trading is inherently exciting (and anything involving money usually is exciting), it's easy to feel like you're missing the party if you don't trade a lot. As a result, you start taking trade set-ups of lesser and lesser quality and begin to overtrade.

I remember a line from a movie (either "Sergeant York" with Gary Cooper or "The Patriot" with Mel Gibson) in which one character gives advice to another on how to shoot a rifle: "Aim small, miss small." I offer the same advice in this new context. To aim small requires patience. So be patient and you'll miss small.

NEXT PAGE: Poor Money Management

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Fatal Flaw 5: Lack of Money Management
The final fatal flaw to overcome as a trader is a lack of money management, and this topic deserves more than just a few paragraphs, because money management encompasses risk/reward analysis, probability of success and failure, protective stops, and so much more.

Even so, I would like to address the subject of money management with a focus on risk as a function of portfolio size. Now the big boys (i.e., the professional traders) tend to limit their risk on any given position to 1% - 3% of their portfolio. If we apply this rule to ourselves, then for every $5,000 we have in our trading account, we can risk only $50 - $150 on any given trade.

Stocks might be a little different, but a $50 stop in corn-which is one point-is simply too tight a stop, especially when the ten-day average trading range in corn recently has been more than ten points. A more plausible stop might be five or ten points, in which case, depending on what percentage of your total portfolio you want to risk, you would need an account size between $15,000 and $50,000.

Simply put, I believe that many traders begin to trade either under-funded or without sufficient capital in their trading account to trade the markets they choose to trade. And that doesn't even address the size that they trade (i.e., multiple contracts).

To overcome this fatal flaw, let me expand on the logic from the "Aim small, miss small" movie line. If you have a small trading account, then trade small. You can accomplish this by trading fewer contracts, or trading e-mini contracts or even stocks.

Bottom line, on your way to becoming a consistently successful trader, you must realize that one key is longevity. If your risk on any given position is relatively small, then you can weather the rough spots. Conversely, if you risk 25% of your portfolio on each trade, after four consecutive losers, you're out altogether.

Break the Hand's Grip
Trading successfully is not easy. It's hard work...damn hard. And if anyone leads you to believe otherwise, run the other way, and fast. But this hard work can be rewarding; above-average gains are possible, and the sense of satisfaction one feels after a few nice trades is absolutely priceless.

To get to that point, though, you must first break the fingers of the invisible hand that is holding you back and stealing money from your trading account. I can guarantee that if you attend to the five fatal flaws I've outlined, you won't be caught red-handed stealing from your own account.

By Jeffrey Kennedy, Editor, Elliott Wave Junctures

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