|03 April, 2019

The psychology of trading: The common pitfalls, and how to avoid them

Trading foreign exchange, equities and commodities can yield big profits, but investors new to the trading world should stick to their plans and preserve their capital.

Image used for illustrative purpose. Hands of Businessman Notebook and documents working .

Image used for illustrative purpose. Hands of Businessman Notebook and documents working .

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Sitting by a pool in an exotic location, laptop at your feet and a refreshing beverage in hand - that’s the stereotype of a successful day-trader. Making money by trading currency, commodities and equity markets – from anywhere in the world – is an attractive prospect, so it’s no wonder that many people are lured in by the promise of easy money.

But the mandatory warnings that flash up on brokerage websites should give pause to any thoughts of achieving quick riches. The vast majority of retail investor accounts lose money when trading contracts for difference (CFDs) on brokerage platforms. Meanwhile, there are no short routes to learning how to become a successful trader. Most investors will need months, or – more likely – years of practice, experience, and losses before they can successfully navigate markets.

 What is a CFD?

One of the most commonly-used trading instruments is a contract for difference, or CFD. These contracts allow investors to trade a rising or a falling market, with the contract tracking the price movement of an underlying market, for example a stock market index, or a heavily-traded commodity like gold, says Konstantinos Anthis, head of research at ADS Securities (ADSS).

With CFDs, there is a bid price and an ask price, the price levels that market participants – such as banks, financial institutions and other traders – are willing to buy a product from you or sell one to you. 

“If you anticipate that the price of an instrument like a stock index or a commodity will increase, you open a buy (long) position with a view to exiting this position when the instrument has reached a higher price. In the opposite case, if you anticipate that the price of an equity or a bond is likely to fall, then you open a sell (short) position with a view to exiting this if the price goes lower,” says Anthis.

Along with the flexibility of CFDs, the fact that they are leveraged means that if a trade goes sour investors can quickly rack up large losses. While investors can use CFDs to increase their profits, they also expose themselves to higher levels of risk, Anthis warned.

Just for specialists?

While trading doesn’t just have to be the province of market experts, learning how to trade will take plenty of time, money and patience. “You can’t learn how become a good trader in three months,” says Bruce Powers, head of trading systems at Relentless 13 Capital.

“Some might do well, but generally there’s no way you will learn it in three months, because to a certain degree you have to graduate through the school of hard knocks.” 

For newer traders, a key point is to protect their capital and minimise losses. A trend across retail trading accounts at City Index is that many investors rack up lots of small wins, but then large losses, Fiona Cincotta, a senior market analyst at City Index, says. “The number of winning trades far outweighs the number of losing trades that go through, but the problem is that when retail investors lose, they tend to lose big.”

Emotion can be a big factor in incurring large losses early on. “A lot of it comes down to trading psychology and also to solid risk management,” says Cincotta.

“A lot of clients will put a stop loss on, but then will be tempted to move the stop loss lower, psychologically messing with their own trade. What we teach clients is to ‘Plan your trade and trade your plan’.”

Two key pieces of advice are to take profit and not to chase losses, says Anthis. “If you have made the profit you set out to in a trade, then close the trade and bank the profit. This means that you are trading in a disciplined way,” he said.

And if a trade turns out to be losing, one mistake is to stay with the trade or even increase the size of the trade in the hope it will eventually work out, says Anthis. Though there may be some chance the trade will turn in your favour, “you will be taking on much greater levels of risk”.

“So, if the trade does not work you will have multiple losses. It is vital to close out and get out, and preserve capital for future trading,” Anthis says.

One important factor that will affect the size of profits and losses is volatility, says Anthis. “If there is a stable market with low volatility then investors can make steady profits. If there is high volatility, profits may be much greater but there can also be much larger losses.”

Exchanges and brokerages

When selecting a venue to trade, key concerns include trading volume, liquidity, depth of market, levels of open interest, and bid-offer spreads, says Les Male, CEO of the Dubai Gold & Commodities Exchange (DGCX). Typically the bid-offer spread is a function of the balance and cross-section of counterparties on an exchange, he adds.

“When I look at my market, typically there is a 1 percent spread, very tight. If you’ve got global players accessing global markets, there’s arbitrage opportunities to tighten any gaps across exchanges, so the liquidity will always migrate to the tightest exchange, because it’s the best price you can get for your bid or your offer,” Male says.

When selecting a brokerage, traders should check that the firm is credible and financially secure – well-capitalised firms can access the levels of liquidity needed – that it is well-regulated, and that it is investing in technology, says Anthis.

“Many firms only offer white labelled products which they have no control over. You should look for a firm with proprietary technology which gives greater flexibility and has the option to develop products and services in a way which provides you with unique market access,” he adds.

Learn without losses

Most good brokerages offer extensive training and education, while demo accounts will allow investors to test their strategies and learn from mistakes without risking losses, says Anthis.

Male said that around the exchange there is a pool of knowledge and experience that traders and trading firms can tap into. “There are lots of intelligent traders in the market, and brokers, exchanges, banks, they are very willing to meet and discuss topics, in terms of bringing forward the knowledge base and the intelligence that exists there.” 

And while brokerages may have a responsibility to educate their clients, at the end of the day the responsibility to be informed lies with the investors who are putting their funds at risk, believes Cincotta. “The more we educate the client the better they will trade, but obviously there is only so much [a brokerage] can do – a lot of it is on the client,” she concludes.

(Reporting by Stian Overdahl; Editing by Michael Fahy)

(michael.fahy@refinitiv.com)

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© ZAWYA 2019