Traders can base their trades on fundamental or technical analysis, or by using insider information, but the main test of a successful trader starts once he enters a trade. Instead of going through an emotional rollercoaster and making irrational decisions, one of the most important aspects of being a successful trader is to manage emotions.
Trading is risky and attracts thrill, just like a sport as scuba diving does. These risky sports provide intense pleasure but are dangerous and much thought process isn’t involved to make a decision. Trading is similar in the way that when we purchase a risky stock, we get an entertainment value, but we are most likely going to lose our money too. We can succeed in trading only if we handle it seriously. Emotional trading is very lethal. Practicing defensive money management can help us in ensuring success. "A good trader watches his capital as a professional scuba diver watches his air supply.”
Why do most traders lose?
Professional traders lose their money primarily because of three main reasons:
A) Emotional trading,
B) Thoughtless Trading, and,
C) The markets are made in a way that most people will lose money most of the time.
Trading is a minus - sum game, i.e., losers lose more than winners win because there is a specific amount of commissions and slippage involved each time we enter and exit a trade, and that is why most people lose money in the markets.
Slippage is nothing but commissions, brokerage and other charges that are required to be paid when executing a trade. Slippage drains out money from the system which a new investor, who has just entered the market, cannot understand.
There are three kinds of Slippage:
- Common – This kind of slippage is due to the spread between buying and selling prices, i.e., the bid-ask spread. Let's try to understand this by an example. A broker may quote us a price of $350.45 for a stock. If we want to buy that stock, we will have to pay at least $350.50 or more, and if we want to sell that contract, we will receive $350.40 or less. This 10 point difference between the buying and selling price, is the bid-ask spread is the profit of the brokers for maintaining inventory, etc. These spreads are smaller in liquid markets and tend to get larger in the illiquid markets.
- Volatility Based – Slippage rises as markets get more volatile. When markets get high, slippage points get high, and vice – versa.
- Criminal - This kind of slippage is a way by which brokers can steal our money. Brokers might execute more trades, just to increase their commissions. Another way can be by putting bad trades into your account and keeping good trades for themselves.
To reduce slippage:
- Trade-in liquid markets,
- Avoid volatile markets,
- When the market is quiet, go for long or shorts.
- Use limit orders,
- Buy and sell at a specified price,
- We can keep a record of prices of the time when we place our orders, and fight the broker if we find any discrepancies.
Commissions can be anywhere from $12 to $100 every time we enter and exit a trade. To understand the magnitude of commissions, let us take an example: -
There is a contract worth $10,000 involving 5000 bushels of corn. The commission for this contract is $30, which according to a broker, is less than 1%. But in reality, we have to first deposit a $600 margin to enter this contract. This means we have to make 5% on the committed capital just to break even. Now suppose we trade this contract 4 times a year, to break even we have to make 20% in profits. 20% to not lose any money, very few people can achieve this, and this is why most of the people lose their money in the markets.
The logical thing to do here is to trade with those brokerage houses that charge the lowest commissions. If possible, bargain with the broker for lower commissions.
Trading cannot be achieved if one keeps fantasizing about supernormal profits. The reality of trading is that it takes time and patience to be a successful trader, and a person's distorted realities can hinder his success.
The goal of a good trader is not to make money, instead, the goal is to trade well. If the trade is a success, the money is a guarantee. Markets offer unlimited opportunities to trade well. As traders, our main goal should be to find good trades and execute those trades.