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Common trading mistakes: part three

Not cutting your losses

It's inevitable - sometimes things don't go to plan and you end up with a running loss on a position. There will be times when you can ride out the storm and eventually turn a profit, but on some occasions it's best to quit before the situation worsens.

So how can you tell whether you should hang onto your losing position or not?

Question

Not cutting your losses

Richard and Jack have both opened long positions on the FTSE at the same time. Unfortunately, they picked the wrong moment to buy: the index is now sliding and both are seeing increasing losses.

Richard likes to trade on instinct, and he has a feeling that the FTSE will soon rise again. He doesn't set any stop-losses, preferring to monitor the market and make decisions on the fly. The loss figure on his FTSE trade is now making him hot under the collar, but he tells himself everything will be fine if he just holds his nerve.

Jack, on the other hand, takes a disciplined approach to trading. He has created a trading plan to outline his strategy, and he follows its guidance when deciding whether to close a position. He also keeps a trading diary and refers back to his previous trading decisions. He has set a stop-loss to automatically close his FTSE trade if losses reach an intolerable level.

Which of these two traders is more likely to make a wise decision about whether to exit their FTSE trade?

A. Richard
B. Jack

Answer

- Although instinct can have its place in trading, experts generally agree that a more ordered, strategic approach is the key to consistent success – particularly for the less experienced. The right decision on any given trade may vary from person to person, but by using tools to help you stay objective, you’re more likely to make choices that leave you feeling satisfied with the end result.

Overexposure or underexposure

With an almost infinite range of financial markets and trading products to choose from, one problem a trader is unlikely to have is boredom.

However, sometimes it can be tricky to strike the right balance between, at one extreme, trying your hand at everything and, at the other, sticking only to what you know well. While it's risky to go too far outside your comfort zone or spread your capital too thinly, you shouldn't restrict your options excessively either. Just keep in mind, the wider the range of asset types you trade across, the more time and energy you'll need to monitor the factors affecting each one.

Overexposure or underexposure

Misunderstanding trends

Imagine the Dow Jones has been steadily moving upwards over the long term, when a worse-than-expected non-farm payrolls report causes it to tumble. Does that mean it's now in a downtrend?

Misunderstanding trends

Inexperienced traders might assume the answer is 'yes', but in fact that's unlikely to be the case

A trend is the long-term direction a market is taking.

Generally this is determined by macro-economic influences rather than individual political or economic events. So, in our example, you might see the Dow resume its uptrend after the initial volatility subsides.

There's an abundance of software available to analyse market trends, and these tools can be valuable if used correctly. You should just be careful to distinguish between short-term and long-term influences, as these may not be aligned.

Lesson summary

  • Be disciplined about closing your trades to cut your losses when markets move against you
  • Maintain a balanced exposure to a range of assets, while taking care not to diversify too far
  • Remember the differences between long-term market trends and short-term reactions or 'sideways trends'

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