Anyone who does it for a living would tell you that day trading certainly isn’t a way to easy riches. With failure rates among day traders especially high it’s worth looking at some of the most common causes of failure and knowing how to avoid them.
1: Too much leverage
Margin trading lets anyone with a modest amount of cash take part in professional markets like forex. It allows them to control much bigger position sizes through leverage.
Normal trading profits will vary plus or minus a few percentage points over any period. However these movements will be magnified by the amount of leverage that’s used. The higher the leverage, the greater those swings into profit and loss will be.
Whereas leverage can make wins more profitable, it also makes losses more painful. That means using too much leverage can be an expensive mistake.
Low margin and high leverage greatly increases the chance of large losses and receiving a margin call.
Many brokers entice us with low opening balances and astronomical leverage. Not surprisingly so because the fees a broker receives are based on volume, rather than amount of margin.
That is, more leverage means higher fees as a proportion of the account size. Going a step further some brokers will apply extra fees for high leverage trading.
2: Ignoring trading costs
Another big mistake is to ignore trading costs. Bear in mind that nearly every action on an account, whether that’s filling an order or just holding an open position overnight, costs money.
Trading costs will cut into profits so they have to be reduced by any means possible.
The two main charges to watch for are spreads and rollover – otherwise known as swap charges. Watch for commission as well particular when trading futures or through an ECN broker.
The break-even point for profits versus fees will depend to a large extent on the trading strategy.
When the average per trade profit is very small, a significant proportion of total profits are absorbed by the spread. With scalping for example, if a trader makes just a 10 pip profit per trade, then half or more of their overall profit can be taken-up by trading costs.
Then again, for a long term position trader, who makes 500 pips per trade, their trading costs might only represent 1% of total profits. See the table below.
|Take profit level (pips)||10||20||100||150||500|
|Cost of spread (5 pips)||50.0%||25.0%||5.0%||3.3%||1.0%|
Many new traders start by trading intra-day. Intraday trading costs are high in relation to profits. In the short term at least, the odds favor the market maker (and broker) because of trading fees.
Those traders who hold trades open overnight have to pay a rollover fee. And with brokers charging rates of between 0.14% and 7.2% pa per lot, this can add up to substantial sums of money over time – especially when using high leverage.
In addition to the transactional fees there will be account maintenance charges, charges for making transfers, and possibly even charges for low turnover.
Underneath the known and publicized fees there are other costs that arise from slippage and poor price execution. These are not to be underestimated. If the slippage is always in your broker’s favor, then this is a de facto additional fee. It will eat into profits in the same way that spread and swap charges do.
3: Having too short a time horizon
When embarking on a trading career, it is reasonable to want to make a profit as soon as possible. The problem is when there is a false belief that profits can be achieved very quickly.
Financial markets are by their nature highly unpredictable. All strategies have good months and bad months, as well as good years and bad years. A trading strategy can’t be properly assessed over a period of days or weeks.
Trying out strategies over too short a period can lead a trader to assume that profits are much better or worse than they really are.
Performance needs to be averaged at least over several months, if not years. When trying out new strategies those in an urgency to see profits often exit at the worst possible time – that being the first time the strategy hits a losing streak.
Quick returns are commensurate with higher risk. The strategies that try to deliver profits quickly are generally higher risk than slow and steady strategies that deliver the same profits over longer periods.
People who look for easy money invariably pay for the privilege of proving conclusively that it cannot be found on this earth. Jesse Livermore
4: Not being properly diversified
Not putting all of your eggs into one basket is simple yet so often a disregarded piece of advice.
A lot of new traders believe that focus is the key to success. By this they will trade one or maybe two markets at the same time, and look at their results as they go.
This might be a simple way to get going and is good for practice. But betting real money on just one or two markets is risky just as holding only one or two stocks in your portfolio is risky.
A strategy that spreads risk by diversifying across different markets and asset types is more likely to succeed in the long run.
The turtle trader experiment is a good example for the need for diversification of any trading system.
It’s not unusual for institutional trading programs to wager hundreds of different markets at the same time. This is to guarantee enough diversification. And while this isn’t going to be possible for the average individual, it does remind us of the need to spread risk.
5: Not using all available information
Institutional traders have a lot of valuable information available to them. They may have insight into order flows, of speculative money, as well as rumors about activity broadly across the markets. Those in large organizations have teams of researchers and analysts to back them up.
This means the odds are on their side when it comes to predicting the direction of markets – at least in the short term. This can put them at an advantage to retail traders.
Despite this there’s still much information that is available online that is accessible to anyone who’s prepared to look. The trader who seeks out all relevant information and arms themselves with knowledge is more likely to be successful over time.
The good news is that most of the above causes of failure are very easily remedied by taking a few simple steps.
- Go easy on leverage
- Make sure your strategy is diversified
- Choose a broker wisely
- Understand and try to minimize your trading costs
- Have a realistic trading plan
By doing this you’ll be ahead of 95% of the crowd.