The Worst Mistake a Trader Can Make

• Posted by Robert Sinn
• on June 20th, 2012

We’ve heard the laundry list of trader pitfalls time and time again – they range from overtrading and adding to losing positions to fighting the trend, indicator abuse, and not allowing profits to run on winning trades. These are all great pieces of wisdom, however, the one pitfall which I have seen hurt traders more than any other and from which many of the other pitfalls are often derived is trading too large.

Trading too much size as a percentage of ones account leads to many of the other pitfalls because it affects the trader’s decision making and causes them to do things that they otherwise wouldn’t do such as:

• Overtrading resulting from stops that are too tight because the position is too large
• Not adhering to stops and/or adding to losers because “they can’t take such a big loss”
• Using confirmation bias and/or indicator abuse to justify remaining in a trade that they would otherwise close out
• Taking profits simply because the trader has a big P&L not because it’s objectively the right decision
• Subjecting oneself to market noise (small price deviations) instead of being able to withstand normal market fluctuations because the position is too large

Anyone who doesn’t understand leverage should set up a forex demo account for the fun of it. By doing this you will understand the greatly reduced margin for error that leverage entails. I have a good friend who works for a major forex trading firm, he tells me that the longevity of retail forex trading accounts is directly correlated with the amount of leverage the accounts use on average (more leverage equals less longevity). In forex you can leverage 100-1 which is crazy, in equities we can usually ‘only’ leverage 4-1. However, 4-1 leverage is very substantial and can easily lead to account blowups.

From my experience the best traders never have a position sized above 25% of account equity; think about it, if you take a 2% loss (normal market variance) on a 25% position you have lost .50% of account equity, this isn’t too damaging and is in fact quite normal. However, if you go cowboy style and take a 2% loss on a 4-1 levered position you have just lost 8% of your account equity – a devastating loss in my book. I highlight the extreme leverage to make a point about how leverage can be really quite toxic.

One of the best pieces of simple advice that I ever received during a cold streak was to trade smaller and to slowly rebuild my confidence. It works! And remember that cowboys get carried out in body bags at the end of the movie, don’t be a cowboy.

 

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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