Cardinal Sins of Trading

Cardinal Sins of Trading
 
A wise man once said that there is usually only one way to do something right, but a thousand ways to do something wrong. So it goes with trading: There are far more things you can do wrong than right, so this has to be an important topic of discussion.
 
Some of the classic mistakes were covered earlier, but here is a list of the top unforgivable sins of trading (“unforgivable” because if you commit these, you will eventually get wiped out and there is no recovery).
 
1. Averaging Down
 
This means that you add more shares to a losing position. It is called “averaging down” because when you add more shares at a lower price, your cost average is smaller. Some financial advisors actually teach this method when it comes to buying long-term holdings or mutual funds. While this might make sense if you are feeding a retirement account over decades, averaging down is a suicide move for trading.
 
I can honestly say that my steepest losses have occurred from averaging down. In fact, it is possible that you could destroy your account beyond any hope of recovery if averaging down cascades out of control.
 
Once my nephew first learned about trading, and he opened an account with ScottTrade for $5,000. After successfully running the account up to $11,000 in less than a month, he decided to enter a hefty position on a stock that was getting hammered on bad news. He assumed it was oversold and would bounce handily.
 
Unfortunately, the stock fell even harder, and he found himself down 7% in less than a day. Instead of taking the loss, he bought more at the lower price. The stock fell again. Feeling trapped, he felt he had no choice but to continue “averaging down.” In less than a week, he was all-in on the position, and his account had fallen from $11,000 to $3,200.
 
He eventually gave up, sold the position at a terrible loss, and closed his account. I do not believe he has ever traded again. Had he sold on the first downturn, his $11,000 account would have fallen $800 to $10,200---which is terrible---but far better than falling from $11,000 to $3,200. And he might still be trading today.
 
The only thing worse than averaging down is to average down and it works. This is very unfortunate, because if you commit this sin and it works out, you will likely continue this practice again, eventually to your ruin.
 
Don’t average down---ever!
 
2. “I can’t Sell Now”
 
I have heard these famous last words more times than I can count. This scenario develops as follows: You assume a position, at falls. It reaches the point of no return (at which time you should exit), but you decide to hold on. After all, the stock might rebound, right? So you continue to hold on and hope. Eventually, the losses are so steep that your only hope of recovery is to hang on indefinitely. You just “can’t sell now.”
 
Over the years, I have encountered so many people who bought a few stocks, they went well under water, and they continue holding them to this day. When I ask why they can’t unload them, they say, “Well, I can’t sell now.”
 
A variation of this is, “I know if I sell them now, they will take off.”
 
Naturally, the argument could be made that they should have sold when the stock crossed the threshold of realistic recovery. If a position is down 20%, it has to gain twice that much just to get even, and how often do you see a 40% gain? Chance of recovery at such levels is little to none.
 
Honestly, you should shed the “can’t sell now” mindset and jettison the position. If you do that and it takes off, so what, you had no business in the trade to begin with. Remember that losing positions are dead money: You are much better off to free the capital to do new, intelligent trades.
 
Alternative: If you find yourself in the “can’t sell now” syndrome (sitting on a deep loss), then do the following. Pretend you have entered the position for the first time, then adopt a firm policy to follow sound trading rules. For instance, if your usual rule is to sell when the stock loses 2%, then sell your deep loser if it drops 2% from where you hold it. Otherwise, hang on and see if it gains. But this is an alternative if you can’t get yourself to sell unconditionally.
 
Second alternative: If you hold a lot of shares, you can recapture some of your losses by selling covered calls. This will be discussed in detail in a later section.
 
3. All In
 
“All in” means that you place all (or mostly all) of your account on a single position. This is a close cousin to “averaging down.” Frankly, this is an act of desperation, even though you might think of it as a “sure” play. Show me a trader who goes “all in” and I will show you someone who loses everything.
 
Going “all-in” does not always mean that you use your entire account for one trade. If you routinely allocate ¼ of your trading power to a trade, a sudden shift to ½ or more is also a form of going “all-in.”
 
Adhere religiously to the rule about trade allocations---no more than ¼ of your trading power on any one trade.
 
A typical reason a person goes “all-in” is due to tiny accounts. Perhaps they started with very little, or continuing losses eroded their trading power to small levels. Either way, if your trading power is insufficient to make safe, intelligent trades (and to overcome the commissions), then don’t trade. At this all-in level, you are merely gambling, and you are shifting from the side of the “house” to the side of the gambler.