Five common trading mistakes and how to avoid them
“If you have more than 120 or 130 of IQ points, you can afford to give the rest away. You don't need extraordinary intelligence to succeed as an investor,” said superstar trader, Warren Buffett.
Forex trading isn’t rocket science but it does require discipline. By following some straightforward guidelines, aspiring traders can progress along the learning curve to become consistent and profitable traders in a relatively short period of time.
However, most traders fail to respect these basic yet essential rules, which are:
- Follow the trend.
- Sit on your hands until there is a trend to follow.
- Cut losses as soon as logically possible.
- Let winners run as long as logically possible.
- Know Your Indicator (KYI).
In this article, we’ll review these ideas using some examples to explain how following these guidelines can help keep traders out of trouble.
Following the Trend
AUDNZD 4H chart—Pepperstone MT4 with Sentiment Trader Smart Trader Tool.
Retail traders can often struggle to identify and then follow trends.
When a trend is developing, retail traders usually fight it and attempt to pick tops and bottoms within the trends range.
Pepperstone's Sentiment Trader Tool regularly highlights this type of behaviour, and we often find that when there is a clearly defined uptrend, retail sentiment and hence retail traders are on the short side as they attempt to fade the rally.
When there is a clearly defined downtrend, retail sentiment will often be on the long side attempting to pick a bottom. Market parlance says it’s an 'attempt to catch a falling knife'.
Highlighting this behaviour
The chart of AUDNZD shown above is an excellent example of this type of behaviour. For the whole month of February 2017, the AUDNZD rate rose steadily and for four weeks in a row, AUDNZD posted an ongoing series of higher highs and higher lows.
That combination is the very definition of an uptrend and the longer we see this combination being repeated, the longer and likely the stronger that uptrend will be. (In contrast, a downtrend is characterised by a series of lower lows and lower highs.)
So, what does the Sentiment Trader tell us about retail positioning during this period?
It tells us that only 19% of retail traders were long, and therefore that 81% of retail traders active in AUDNZD, were fighting or opposing that long-standing trend.
Going with the flow
Based on this kind of evidence, it seems that many traders do indeed have trouble identifying a trend and then trading with it.
To some extent that's understandable. After all, it is entirely possible for longer and shorter-term trends to coexist within the same currency pair or cross, at the same time, and to reveal themselves on charts that are drawn with different time frames.
It’s rare to see a currency trending in the same direction across all chart time frames but it can happen, for instance when momentum is strong and is being driven by significant news or macro events.
Usually, however, the natural ebb and flow of supply and demand tends to confuse retail traders, who are viewing the markets over multiple time frames.
To simplify the concept of multiple and potentially conflicting trends simultaneously active in the same instrument, it might be helpful to think of it like this:
Markets, and FX, in particular, tend to trend over the longer-term, deviating from and then reverting to the mean (or longer-term trend) over the shorter term.
In the world of retail trading keeping things simple is generally the best practice - following a trend is effectively just going with the flow of the market.
Here are some straightforward suggestions that can help you to identify and act on trends.
Stick to a single time frame (usually daily) for trend identification.
Shorter-term time frames can be used to "zoom in" on a trend to identify potential trade entry and exit levels and to inform the placement of stop losses. The trend should be identified and monitored using one primary time-frame, consistently.
Use Pepperstone’s Sentiment Trader and wait until the crowd is structurally on the wrong side of a move.
The Sentiment Trader is one of Pepperstone’s Smart Trader Tools: a dedicated software suite that is designed to enhance and improve your trading experience, on both the MT4 and MT5 platforms.
Sentiment Trader monitors long and short positions among retail clients, in real time, to assess the overall sentiment in a given instrument or pair. A summary of this data is then displayed via the indicator as a percentage, both numerically and in the fuel gauge like icon, seen in the image below.
When the Sentiment Trader shows readings below 40% for an instrument in an uptrend, or above 60% for an instrument in a downtrend, you can be quite confident that a stable trend has emerged.
From this point on, traders should be looking for trade opportunities or entry points that follow the direction of the prevailing trend and are in opposition to the majority of other retail traders. So that’s long positions in uptrends and short positions in downtrends.
Let institutional traders highlight trends for you
The so-called non-commercials are nothing more than large speculative accounts such as Hedge Funds or CTAs (Commodity Trading Advisors).
These speculators are longer-term trend followers by nature. So by simply keeping track of what they are doing, you are staying in touch with existing trends and also the points at which those large speculative traders move into and out of them.
The good news is that you don't have to do this for yourself. There are many services on the web that track, report on and analyse the COT data. One such service and the one that I use is countingpips.com, but there are plenty of others out there.
Following the non-commercial entities is a handy and non-discretionary way of identifying and staying in touch with a trend and the pro-traders who are following it.
However there are some drawbacks to using the COT reports in isolation.
Firstly, the reports are only applicable to the FX Majors, Indices and Commodities. The positioning in FX crosses, minors and exotics are not tracked.
The reports are backward looking, in that they are published on a Friday evening using data that was collated on the preceding Tuesday. So positions and market trends could well have changed between the points at which the information is gathered and published.
Overcoming these shortfalls
There are methods we can use to try and overcome these limitations. These large speculators are very technical in the way that they identify and follow trends.
To some extent, we can mimic their behaviour by examining our charts using three complimentary time frames, which are:
13 weeks or 65 days (approximately one business quarter) - red line
26 weeks or 120 days (approximately half a year) - green line
52 weeks or 240 days (approximately one year) - blue line
As we noted earlier, we want to stick to a daily chart time frame to identify market trends. By adding simple moving averages (based on the periods listed above) to our daily chart, we can quickly get a handle on what the long term price action and price trend in a given instrument has been. By using that in combination with the COT reports we can get a good approximation of what the non-commercial speculators are doing and the direction and longevity of the trends that they are following.
I have drawn a daily chart of EURUSD below, with SMA lines set to these specific time frames.
All three lines have trended lower over the duration of the chart, as has the price action in the pair.
Don’t trade until there is a trend to follow
Our second key guideline is to ‘sit on your hands’ and refrain from trading unless or until there is a clear trend in place. Doing nothing is often the hardest thing for any trader, but trading for trading's sake is almost always a sure fire way to lose money.
Of course, there are alternative ways to trade that do not rely on trends to create an edge. However, retail traders often have part or full-time jobs, which reduces the amount of screen time they have at their disposal. These time constraints also reduce the amount of research and analysis that can be done before pulling the trade trigger.
The bottom line is that retail traders are better off being light on their feet, not overcomplicating their analysis, and keeping their trading criteria equally simple.
Trade with an edge
Trading with the trend fits this bill because it only requires a short period each day looking for, identifying and filtering higher quality or long-standing trends that are in the market, at any given time.
More critical still is to avoid trading off of trendless charts (unless you are a full-time scalper) and in markets where you as a trader have no tangible edge, which is akin to tossing a coin and therefore a binary event with 50/50 odds.
The theme of an edge is a recurring one within trading, and a successful trader does all that he or she can to slant the odds of success in their favour, or if you prefer, to give themselves the best possible edge for every trade.
Cut your losses as soon as possible and ride your wins for as long as you can
Have you ever held onto a losing trade, thinking that the market “had” to turn around sooner or later? This is a direct violation of the one rule that we simply cannot afford to ignore: cut your losses quickly. In the same way, we should be looking to hold onto our winning trades as long as logically possible.
We’ve all been here with a losing trade, and when we were, we were subject to what‘s known as a cognitive bias. In this case, loss aversion. These types of biases are thought to be hard-wired into our psyche by evolution, and are instinctive to some extent.
We can learn to recognise and overcome them. Once again, a rule-based approach can help.
Monitor your trade
The process of monitoring your trade after the initial entry is known as ‘trade management’, an area not covered in any great detail within classic trading books.
So how do we formulate a plan that helps us cut losses as soon as it's logically possible, but no sooner? And how can we know when it's appropriate to hold onto a position?
The most straightforward idea is to let the market tell you when it's right to hold, and when it's time to fold.
Simple tools that can help you manage trades successfully are:
- Peak/trough analysis
- Price behaviour
- Common sense
In the daily chart of AUDNZD above, we have drawn a breakout entry (blue line), and we’ve highlighted potential resistance points above that entry. For the ill-prepared trader, these resistance points might be seen as 'reasons to exit the trade'.
There is a better way to decide?
Stay long while the market tells you to
In the chart above, an hourly plot of AUDNZD, we’ve used a simple peak/trough analysis method and swing levels found on the daily chart to aid our trade management Once again, the blue line signifies our entry point.
This method tells us that it's right to stay long while the price action continues to print higher lows over the shorter-term time-frame (in this case on the hourly chart) behaviour that is in line with the bias on our daily chart. Remember that higher lows are an integral part of an uptrend.
Get out when it doesn't
When we run into stiff resistance, in this example a pattern known as a triple top, at a key level, we can use the recent lows to inform the placement of a trailing stop (the thin red line in the chart above).
If we are subsequently stopped out by the appearance of lower lows (an integral part of a downtrend) in the price action, we will have captured the majority of the upside in this trade and have exited in a sensible and logical manner.
We can use a similar method to identify potential price points at which to re-enter on the long side and use the near-term lows to optimise the placement of our trailing stop loss, as and when we meet new resistance as set out below.
Without a formal structure for managing your trades, it will be a struggle to keep emotions at bay and to trade in a consistent and logical manner.
Know Your Indicator (KYI)
The charts we have looked at in the article so far have not shown any indicators apart from simple support and resistance lines. Many traders like to overlay technical indicators on their chart to aid their decision-making.
That's a great idea if you understand the indicators you are using. However, too many traders fall into the trap of ‘covering’ their charts with technical indicators, without knowing how they really work or what the indicators are telling them.
Without this knowledge and understanding, it's impossible to use any indicator properly, interpret its signals, or decide when and if the indicator might be generating false signals.
Technical indicators are tools and without a clear understanding of what your tool does and what job it's meant for, you won’t know how or when to use it.
Start with something simple
A straight forward tool such as RSI 14 is a perfect introduction to the world of indicators. The RSI 14 indicator is what is known as a momentum oscillator. That’s a bit of a mouthful but what it means is that the indicator is sensitive to changes in the velocity of the price. Or if you prefer, the rate at which it changes in either direction. The indicator works by comparing the current rate of change with the average rate of change over a set a number of historical periods, usually set at 14. That measure of relative strength is then plotted as a line on a chart which is typically displayed below our price chart. In the image below RSI 14 is the green line in the window below our main chart.
There are classical overbought and oversold boundaries for the indicator set at readings of 70% and 30% respectively, within a maximum range of 0 to 100%.
I have highlighted some points above at which the indicator reaches or exceeds these levels, often reversing course soon after. Though be aware that the underlying price can continue to move higher or lower regardless of the indicator’s readings.
The RSI 14 indicator can overextend as a result, and though readings of 100 or 0 would be very rare, readings of 80 or 20 are not uncommon.
Over to You
In this article, we have looked at five common trading mistakes and offered some solutions you can implement to fix them:
- Keeping your charts clean and uncluttered
- Following clear and established trends
- Sitting on your hands when there are no trends
- Cutting your losses quickly and letting profits run
- Knowing exactly why you're using specific indicators.
You can keep your trading logical and have a much higher chance of making the right decisions at the right time in the markets. All of this makes for disciplined and consistent trading, as opposed to emotional trading, which can harm retail trading accounts.
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