FREE REPORT: Four Big Mistakes that Traders Make and How to Avoid Them

The definition of insanity is doing the same thing time after time and expecting different results. Unfortunately beginning and even experienced traders, who have not progressed to making money on a steady basis, tend to make the same mistakes time after time.

And those mistakes are not related to fundamental research, chart reading, interpretation of technical indicators, or specific buy and sell techniques. Rather they stem from a trader's mental approach to trading.

The practical tools: fundamental research (sorting through a company's financial data, its earnings and cash condition, and its future growth prospects), technical analysis (reading charts, interpreting indicators like volume, relative strength, momentum etc), and understanding what type of orders to use and when (limit orders to enter a trade, stop loss orders to protect a trade, and market orders to exit with profits) are simply tools.

Every mechanic has a set of tools but we all have known one of more who were able to perform virtual "magic" on our cars while others with the same tools plod along helping sometimes, but only making things worse other times. They just don't have the skill or abilities of that great mechanic.

The same goes for traders. Now with home computers and easy access to the Internet we all have access to the same basic tools that in days past were thought to give significant advantages to a select few. But surprisingly enough, the widespread availability of timely information and analytical tools that only 20 years cost so much that only the very largest institutions or the very wealthiest of individuals could afford, has not resulted in a greater percentage of profitable traders. The reason why is that traders today make the same mistakes as traders did long before the PC or the Internet. Better tools do not make for better traders.

During the late 1990s the roaring bull market combined with the stunning technological advances to give all too many traders the illusion that times had changed forever. Most of you know people who made huge profits in a few short years. These same nouveau traders were suddenly "experts" willing, in fact all too willing, to share their so-called "wisdom" with the masses.

The rise of day trading on home computers was the final stage of this speculative bubble that was building up to burst mightily. You remember the ads: "You can make a great living trading while sitting in your underwear trading with your computer in your own home!"

Of course the market topped in March 2000, and over the next 3 years the NASDAQ, where the biggest gains had been made, crashed 75%. Many stocks did even worse. And all too sadly, most traders caught up in their own feelings of invincibility wound up not only losing their profits but often much more.

Successful traders know that the business of trading is part art and part science. If science alone was enough, then all you would need would be a computer program to pump out buy and sell signals based on back testing of stock data back to the beginning of the market. But such a program does not exist regardless of what you may read in wild eyed advertisements. If it did, the developer would already have won most of the money in the world and wouldn't need to sell it to you for $1,000!

In the pages that follow we detail the four biggest mistakes that traders make. This is based on over 30 years trading experience in the trenches ourselves as well as extensive interviews with many traders from the stock to the options to the futures markets. What is amazing is the consistency that these traders exhibit when asked to decipher what mistakes a trader must avoid to be consistently successful.

Mistake #1 Failure to have a consistent trade selection method

Most traders, most advisories, most Internet chat groups talk about profits profits. Few ever take the time to point out that profits are actually relatively easy to handle. Losses are the hard part of trading. And yes, they are an inevitable part of trading. Until you learn, understand, and live with this fact of trading you will never succeed over the long term. A good case in point are all those big talkers in 1998-1999 who you never hear from anymore.

The key to separating yourself from the mass of losing traders is developing a consistent method for selecting your trades. Your trade selection plan should be written out. It should spell out the factors that MUST be present to buy (or sell short) prior to taking action.

Factors to base your trade on could consist of things such as earnings. For example many successful traders will only buy stock in companies that show an annual earnings growth rate of 25% to 50%. Earnings are reported quarterly. If a company shows two consecutive quarters of decelerating earnings, that may be the signal to sell the stock or even consider going short.

It is not the purpose of this essay to detail every possible trading plan. We recommend that you take a look at William O'Neill's How to Make Money in Stocks, as one good starting point, though there are many others. Earnings growth is only one factor and not necessarily the most important one.

Other traders like to concentrate on technical factors. For example, they only want to buy stocks which are going up faster than the market as a whole. This is called relative strength. It is common to compare a stock's rise in price to the S&P 500 index. If it is rising faster than the S&P Index, then it is outperforming the market. That is has a strong relative strength. It is strong relative to the market as measured by the S&P 500 index. It stands to reason that stocks that outperform the market averages will be the biggest winners over time.

In another report of ours: How to Use Four Free Internet Site to Increase Your Profits, we detail for you the exact web addresses where you can locate information on earnings, growth rates, cash flow, relative strength, chart patterns, and a myriad of other potential inputs.

The most important tip we can give you here is to keep it simple. Don't get caught up with developing a 30 point checklist. You will never make a trade then. Include parameters that make sense to you. If buying high relative strength stocks does not make sense to you, then don't do it.

One of the most successful investors of all time, Peter Lynch, based his whole investment philosophy on buying only those stocks that made sense to him. He got some of his best ideas from his wife who would come home and tell him about a great new store or product she discovered while shopping the mall. He'd do a bit of research and sometimes that company would be in the early stages of a great growth cycle.

The Internet with its flood of information makes it all too easy to create trading plans that are so convoluted and complex that they may be great in the world of theory but useless in the real world of trading.
Pick out a checklist of 5 to 10 things, combining fundamental factors like earnings cash in the bank, cash flow etc with a few technical inputs such as relative strength, chart formations, timing signals, and/or seasonal tendencies (80% of all the profits in the history of the stock market occur between November and March).

Mistake #2 Failure to Have a Profit Target

Once you know what you want to see to buy a stock, determine a reasonable price target. It doesn't make sense to buy a $10 stock that has the potential to go to $11 over the next year. That is only 10%. If you buy 100 shares of five $10 stocks and they all go up $1 in a year you just made $500. But it wouldn't take much to wipe that out. If you bought 100 shares of a sixth stock at $10, and it dropped to $5 in a year, you would have lost $500 on that stock, and wiped out the gains on your five profitable stocks.

Look for home runs and settle for singles if you must. You want to buy stocks that have real chance to double, triple or quadruple (a four bagger in floor trader parlance). There are many ways to calculate potential upside price targets.

One widely used approach is to check the historical PE (price/earnings ratio of a stock). Let's say that the historical PE for XYZ is 10. Current earnings are $2 per year. The stock would be selling at $20 ($2 multiplied by the PE ratio of 10) if it was selling near its historical average. You then look at analysts' projections for future earnings for XYZ and they project $3.50 a share next year. If the stock sticks with its historical PE you could expect that stock to run up to $35 next year ($3.50 X the 10 PE).

Other traders prefer to base projections on chart formations. History shows that prices move in waves. If the last wave up was $10 from high to low for XYZ, and it was selling at $8 and forming a bottom, a technical analyst might project $18 for the next upside target.

There are many ways to project price targets and profit potentials. It is beyond the scope of this essay to delineate them all. But one thing you must do is to develop a method for projecting profit targets. Otherwise how will you know whether it is worth risking your hard earned money to buy the stocks that your selection method zeroed in on.

Mistake # 3 Trying to Follow Too Many Stocks

There are over 50,000 stocks traded in the United States alone. Add in the rest of the world and you have hundreds of thousands of potential stock investments. Unless you are superhuman there is no way to realistically monitor that many stocks. If you are trading short term where you plan to hold your stock anywhere from one day to 30 days, you need to focus like a laser on a select group of stocks that exhibit a consistent trading pattern that you can easily recognize and act on.
Short term traders should focus on high volume actively traded stocks. Some very successful traders focus on only the 30 stocks in the Dow Jones Industrials. Others look at the NASDAQ 100, a proxy for the technology sector of the market. Investors Business Daily newspaper publishes a list of top 100 stocks based on its proprietary stock selection method every week. The list is available in spreadsheet format on its website.

For intermediate to long term traders, your horizon can be larger since you will not be under pressure to develop new trading ideas on a daily basis. But even here, we caution you against trying to do too much. The S&P 500 index is a selection of the top 500 industrial companies in the country. Its stock components do change periodically though not usually more than once a year. That is a good starting point.
Some traders prefer to buy low priced stocks. "Penny" stocks are stocks that sell for $5 or less per share. Penny stock trading has a bad reputation for a very good reason. There are many charlatans in the business who hawk stocks solely because the underlying companies pay them "marketing" fees. If you like the low priced sector, we recommend that you stick with stocks that are listed on the New York Stock Exchange, the American Stock Exchange, or the NASDAQ. Stay away from the OTC Bulletin Board (BB) and "pink list" stocks. An occasional gem does pop up out of the OTC BB, but the very high risk nature of these stocks outweighs the profit potential for the average investor.

Mistake #4 Failure to Control Your Risk

The single biggest mistake made by traders both new and experienced is the failure to control your risk. In Mistake #2 you learned how important it is to set a reasonable target. If you don't have some idea of the profit potential it makes no sense at all to invest in a stock.

But likewise, if you do not set strict risk parameters and stick with them with unfailing discipline, you will never make money consistently in the stock, option, or futures markets.

The old Wall Street saying is very easy to remember: "Cut your losses and let your profits run." But it is very difficult to carry out. The reason for this is simple: no one likes to admit they are wrong. We all get a little stubborn when it comes to admitting error.

Many traders became investors in the late 1990s when they bought high tech stocks at $100 or more per share, then held those stocks as they fell all the way to $25, $20, $10 or even less. A couple years of dropping stock prices wiped out the profits of most individual non-professional traders. The pros knew enough to cut their losses. They understand that if you run out of chips (money), you can't trade anymore. If you can't trade anymore then you can't make money anymore.

The number one goal must be preservation of your capital. If you are able to preserve your trading capital, then you can always make another trade. That next trade may just be the one that makes you a big winner. But if you lost all your money, you will miss out on that winner!

The secret of trading success is so simple that it is derided by all the high priced experts peddling expensive advice or trading systems. The secret to success is to avoid the disasters - the big losing trades.

It is easy to say but difficult to do. One of the most difficult aspects of the stock market is that it is an accumulation of human frailties being played out on a big stage. Traders quickly learn that the market will do what is necessary to separate them from their hard earned cash.

One of the first things that every trader experiences is to see the stock they bought drop down to their stop loss point. They sell at the stop loss in order to "cut their losses" only to see the stock turn on a dime then shoot higher, doubling or tripling. The first thought that leaps to mind is naturally: "If I only would have held on a little longer, I would have made a fortune."

Trust us, the market will do this time and again. Most traders finally give in and decide that "this time I'm not going to be knocked out just before it turns." Of course what happens "this time" is that the stock does not turn on a dime. It continues to fall. Pretty soon that $10,000 investment has shriveled to $1,000 and you have little realistic chance of making that money back anywhere nearly as quickly as you lost it.

Consider the math. If you buy a $30 stock, and it falls to $15, you have lost 50% or half your investment. But in order for you to get back to "even" the stock doesn't just have to go up 50%, it must run up 100% or double, just to get you back to where you started.

It is far better to take a series of small losses. William O'Neill recommends that you never risk more than 8% on any single stock position. If you buy a $20 stock, that means you should be selling it if it drops 8% ($1.60). That cuts your loss and leaves you with the capital to buy another stock that your selection method ferrets out for you.

Other successful advisors advise that you divide your trading capital into 20 equal parts and never risk more than 5% on any one trade. It would take 20 consecutive losing trades to wipe out your capital. Hopefully you will recognize a problem with your approach long before 20 straight maximum losing trades! There are many money management techniques. We can't say that one is better than another because the best will depend on your capital, your trading temperament, and your profit goals. But it is critical that you adopt a disciplined risk control plan that you adhere to with unwavering fervor.

Harry Browne, the well known investment advisor, once observed that it seems like the goal of most investors was to "get out even" because he heard that mantra so many times. Remember the market does not care at what price you bought. Getting out even is the mantra of a perpetual losing trader. If your goal becomes getting out even, you are lost. Why trade?

Your goal must be to get out with huge profits. Otherwise the wear and tear of trading is simply too much work. You won't always achieve that goal. But if you manage to avoid these four mistakes you will improve your odds of success substantially.

By avoiding these four mistakes, you will move to the upper echelon of all traders. By now you probably understand that stock trading is really simply a test of yourself. Your opponent is not the market, it is you! If you discipline your trading approach to incorporate reasonable investment selection methods and don't make these four mistakes, you will make money consistently regularly over the long term. Don't be fooled, you don't need to invent or buy anything new or revolutionary. You simply need an approach that makes sense to you, that you believe in, and that you can and will apply consistently.

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