Thursday, November 18, 2010

The first question to ask when opening a trade

To the majority of traders, especially inexperienced ones, the first thought after identifying a potential trade is of all the pound or dollar signs flashing in front of their eyes, thinking of how much they can win.

To the minority of traders, who are the majority of the successful ones, they always quantify first how much they can LOSE.

In all cases, they have a stop, either physically placed or just a mental stop, but they always act if that level is breached, no matter what. Analysis of what went wrong always occurs after the event, when the mind is clear.

In my own case, I use spreadbets to trade, and I use the IG Index platform. They allow me to place 'guaranteed' stops when I enter a trade, for which I pay a small premium, which is incorporated in the opening spread on the trade. This enables me to avoid having a stock gap through my stop. The result of this is that I know at all times my absolute risk, both on individual trades and my portfolio as a whole.

The absolute nightmare scenario for an inexperienced trader is when a stop level is breached, but they decide to hold on in the HOPE it reverses in their favour. It goes against them further, then their ego comes into play - "I will be proven right, I don't like taking losses - it will come back". In extreme cases, the trader becomes an investor, being stuck in a position for months or even years hoping that they will break even. This becomes even more apparent if the trader is using too large a percentage of their capital on each trade, and cannot bear the thought of banking a loss that is too big for their own ego, or their trading account.

It is important to remember that your first loss is your best loss. Losses are a cost of business. You've lost on a trade. Big deal - log it and move on - you are one trade closer to finding a big winner.

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