Five Fatal Flaws of Trading
Posted by: Elliott Wave in Elliottwave, tags: elliott-wave, forex trading, trading tipsFive Fatal Flaws of Trading
June 25, 2009
By Jeffrey Kennedy
Close to ninety percent of all traders lose money. The remaining ten percent somehow manage to either break even or even
turn a profit – and more importantly, do it consistently. How do they do that?
That’s an age-old question. While there is no magic formula, one of Elliott Wave International’s senior instructors Jeffrey
Kennedy has identified five fundamental flaws that, in his opinion, stop most traders from being consistently successful.
We don’t claim to have found The Holy Grail of trading here, but sometimes a single idea can change a person’s life. Maybe
you’ll find one in Jeffrey’s take on trading? We sincerely hope so.
The following is an excerpt from Jeffrey Kennedy’s Trader’s Classroom Collection. For a limited time, Elliott
Wave International is offering Jeffrey Kennedy’s report, How
to Use Bar Patterns to Spot Trade Setups, free.
Why Do Traders Lose?
If you’ve been trading for a long time, you no doubt have felt that 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.
Which brings us to the question: Why do traders lose? Or maybe we should ask, ‘How do you stop the 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. For each fatal flaw represents a
finger on the invisible hand that wreaks havoc with your trading account.
Fatal Flaw No. 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 correctly identify the trend.
How to overcome this fatal flaw? Answer: 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 No. 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 setup 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.
Fatal Flaw No. 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.
For a limited time, Elliott Wave International is offering Jeffrey Kennedy’s report, How
to Use Bar Patterns to Spot Trade Setups, free.
Fatal Flaw No. 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 setups
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 setups
of lesser and lesser quality and begin to over-trade.
How do you overcome this lack of patience? The advice I have found to be most valuable is to remind yourself that every
week, there is another trade-of-the-year. In other words, don’t worry about missing an opportunity today, because
there will be another one tomorrow, next week and next month … I promise.
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.”
Fatal Flaw No. 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 10-day average trading range in Corn recently has been more than 10 points. A more plausible
stop might be five points or 10, 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 all together.
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 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.
For more information on trading successfully, visit Elliott Wave International to download Jeffrey Kennedy’s free
report, How
to Use Bar Patterns to Spot Trade Setups.
Jeffrey Kennedy is the Chief Commodity Analyst at Elliott
Wave International (EWI). With more than 15 years of experience as a technical analyst, he writes and
edits Futures Junctures, EWI’s premier commodity forecasting package.
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