WHAT IS THE MOST COMMON MISTAKE MADE BY TRADERS?

Active trading has become highly popular as a result of increased financial market volatility and increased accessibility for the common individual, but the flood of new traders has met with mixed results.

Certain patterns may distinguish profitable traders from those who lose money in the end. And, certainly, there is one particular blunder that, in our experience, is made repeatedly. What is the most common blunder that causes traders to lose money?

Here’s a hint: it has to do with how we deal with winning and losing as people.

As a result of our own human psychology making it tough to navigate financial markets that are full of uncertainty and risk, the most typical blunders traders make involve poor risk management tactics.

Traders are frequently correct about market direction, but the issue is how much profit they make when they are right against how much they lose when they are wrong.

Bottom line, traders tend to make less on winning trades than they lose on losing trades.

Before getting into how to remedy this issue, it’s a good idea to first understand why traders make this mistake in the first place.

A SIMPLE WAGER – UNDERSTANDING DECISION MAKING VIA SUCCESS AND FAILURE

Humans have inherent and occasionally irrational biases that impair our judgment. To highlight this typical deficiency, we’ll use a simple yet significant finding that won a Nobel Prize in Economics. But before, consider this thinking experiment:

What if I presented you with a simple wager based on the traditional coin toss? Assume it’s a fair coin with an equal chance of showing “Heads” or “Tails,” and I’ll ask you to predict the outcome of a single flip.

You’ll earn $1,000 if you guess correctly. If you guess poorly, you’ll get nothing. But, just to spice things up, I’ll give you Option B — a guaranteed $400 profit. Which one would you pick?

EXPECTED RETURN
Choice A50% chance of $1000 & 50% chance of $0$500
Choice B$400$400

Choice A makes the most mathematical sense from a mathematical standpoint, as you may expect to make $500 and hence maximize profit. Choice B isn’t necessarily incorrect. With no chance of losing money, you can’t blame yourself for taking a lower profit. And, of course, you run the chance of making no profit at all if you choose Option A, thereby losing the $400 promised by Option B.

It should come as no surprise, then, that most people will chose “B” in similar studies. When it comes to profits, we are frequently risk averse and choose for the sure thing. But what about possible losses?

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Consider a new perspective on the thinking experiment. In Choice A, I offer you an equal chance of losing $1,000 and winning $0 using the same coin. Option B will almost certainly result in a $400 loss. Which one would you pick?

EXPECTED RETURN
Choice A50% chance of -$1000 & 50% chance of $0-$500
Choice B-$400-$400

Decision B is the logical choice in this case because it minimizes losses. Nonetheless, comparable studies have indicated that the majority of people would chose “A.” We become risk takers when it comes to losses. When it comes to profits, most people avoid risk, but they actively embrace risk if it means avoiding a loss.

Although a hypothetical coin flip exercise is unlikely to cause concern, this basic human habit and cognitive dissonance is plainly troublesome if it extends to real-life decision-making. And it is precisely this dynamic that explains one of the most prevalent trading blunders.

Losses are significantly more painful psychologically than profits.

When presented with prospective profits and losses, Daniel Kahneman and Amos Tversky produced what has been dubbed a “seminal article in behavioral economics,” demonstrating that humans are prone to making illogical judgments. Their research isn’t focused on trade, but it has clear consequences for our research.

The core idea was simple but profound: most people make economic decisions based on their emotions toward winning and losing, not on predicted benefit. It was always assumed that a rational person would make decisions solely on the basis of maximizing gains and minimizing losses; however, this is not the case, and traders exhibit the same contradiction…

We want to make money in our trades in the end, but in order to do so, we need to push past our natural emotions and make reasonable trading judgments.

A $500 gain would completely offset a $500 loss if the ultimate goal was to maximize profits and minimize losses.

However, this relationship is not linear; the diagram below depicts how most people could rank their “Pleasure” and “Pain” resulting from gains and losses.

PROSPECT THEORY: LOSSES HURT FAR MORE THAN GAIN GIVES PLEASURE IN MOST CASES.

Why Most Traders Fail and How to Increase Trading Success

The bad emotion evoked by a $500 loss can be significantly greater than the pleasant emotion evoked by a $500 gain, and experiencing both can make most people feel worse despite no monetary loss.

In fact, we must discover a way to straighten that utility curve by seeing equal gains and losses as offsetting, allowing us to make entirely rational decisions. Even yet, it’s considerably easier said than done.

Why Most Traders Fail and How to Increase Trading Success

THE PRIMARY GOAL SHOULD NOT BE A HIGH WIN PERCENTAGE.

Your main goal should be to locate transactions that give you an advantage and have a risk profile that is asymmetrical.

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This means that your main goal should be to establish a healthy “Risk/Reward” (R/R) ratio, which is essentially the ratio of how much is at risk vs how much is gained. Let’s say you’re correct about half of the time, which is a reasonable expectation. If you want to break even, your gains and losses must have a risk/reward ratio of at least 1.5:1 or even 2:1 or greater.

Too many traders are preoccupied with achieving a high win rate, which is logical given the study we discussed previously on loss aversion. And, based on your own experiences, you almost likely know what it’s like to lose. From a logical sense, however, expecting to be correct 100% of the time is unrealistic. Losing is an inevitable aspect of the trading process, which you must accept as a trader.

It’s more practical and profitable to have a 45 percent win rate with a 2:1 risk-to-reward ratio than it is to be correct on 65 percent of your trade ideas but only have a 1:2 risk-to-reward profile.

Short-term enjoyment from “winning” more often may make you feel good, but frustration will set in if you don’t make any improvements. And a disappointed mind will almost always result in additional errors.

The math is best illustrated in the table below. Over the course of a 20-trade sample, you can plainly see how a favorable risk/reward profile combined with a higher number of losers than winners can be more profitable than an unfavorable risk/reward profile combined with a lower number of losses. The trader who makes money on 45 percent of transactions with a 2:1 R:R profile wins, whereas the trader who wins 65 percent of the time but only makes half as much on winners vs losers loses.

Why Most Traders Fail and How to Increase Trading Success

Which character would you choose to be? The trader who ends up plus 7 units but loses more often than they win, or the trader who ends up slightly negative but enjoys the satisfaction of “being right” more frequently. The decision looks to be straightforward.

GOOD MONEY MANAGEMENT REQUIRES THE USE OF STOPS AND LIMITS.

Working against our innate biases takes effort because humans aren’t machines. The next issue is to stick to your trading plan once you’ve created one with a good reward/risk ratio. It’s human nature to want to hold on to losses and take winnings early, but this makes for poor trading. We must overcome our natural inclination to trade with our emotions.

Setting up your trade using Stop-Loss and Limit orders from the start is a fantastic method to do this. But don’t just set them to obtain a precise ratio for the sake of setting them. You’ll still want to apply your analysis to figure out where the most appropriate stops and limit orders should be placed. Many traders use technical analysis to find spots on the charts that could invalidate (trigger your stop-loss) or validate their trades (trigger the limit order). Determining your exit points ahead of time will ensure that you start with the right reward/risk ratio (1:1 or greater). Don’t touch them once you’ve placed them.

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(With one exception: if the market moves in your favor, you can move your stop to lock in profits.)

There will always be instances when a trade moves against you, triggering your stop loss, but the market eventually reverses in the direction of the trade you were just stopped out of. This can be a difficult experience, but keep in mind that it’s all about the statistics. Expecting a losing trade to turn around every time exposes you to further losses, which might be fatal if they are severe enough. To argue against stop losses because they drive you to lose is counterproductive—their sole function is to push you to lose.

This type of risk management is referred to by many traders as “money management.” It’s one thing to be on the right side of the market, but poor money management makes it far more difficult to generate a profit in the long run.

GAME PLAN: BRINGING EVERYTHING TOGETHER

Set your stops and limits to a reward-to-risk ratio of at least 1:1, ideally higher.

Make sure you utilize a stop-loss order whenever you make a trade. Always ensure that your profit objective is at least as far away from your entry price as your stop-loss is, and, as previously said, you should ideally aim for a risk/reward ratio that is even higher.

Then you can choose the market direction correctly only half of the time and still have a positive account balance.

The exact distance between your stop and limit orders will be determined by market conditions at the moment, such as volatility and where you sense support and resistance. Any trade can benefit from the same reward/risk ratio. If your stop level is 40 points away from your entry, your profit objective should be at least 40 points distant to accomplish a 1:1 R/R ratio. Your profit objective should be at least 500 points away from your stop level if your stop level is 500 points away.

To summarize, accept that losing is an inevitable aspect of trading, set stop-losses and limits to define your risk ahead of time, and aim for optimum risk/reward ratios when planning transactions.

Read also: Trading mindset: become a successful Forex trader

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