Spread Trading Mistakes

A spread bet allows you leveraged exposure to the price movements of financial instrument so you don’t really need to be in positions very long to turn a profit. The key is to use prudent risk management so that it doesn’t cost you an arm and a leg when you get the market direction wrong.

I like spreadbetting because I avoid CGT, I can leverage, I can add to position as it grows and, if I am nuts, I can use open profits on other trades. The last point is bad advice as the new bet elsewhere uses margin that should be resting in case it’s needed for the first bet.

What else? Oh, if you get it right, the returns are mindboggling. But be very, very careful and not greedy. If you start to lose, jump on your losses. Remember, most big losses start off as small ones- gap downs excluded.  All IMHO, door, etc and be careful – losses can be more than your original deposit.

  • Not Understanding Leverage

A common mistake that most beginner traders make is that they deposit a small amount and start taking on big positions without realising that the leverage cuts both gains and while gains can be magnified, the potential for bigger losses is also increased. You have to understand the true exposure of your trades and have a clear trading plan with set profit targets and acceptable losses against anticipated market movements.

  • Poor Trade Management: Letting Losses Run and Taking Profits Early

While spread traders frequently commit an inordinate amount of time to selecting, planning and executing new positions, they often make the mistake of exiting these trades with much less thought. This is unfortunate as it is the exit, after all, that will determine whether a trade has been profitable or not.

This is where the spread traders’ enemies of hope, fear and greed make an appearance. It is human nature to grasp quickly at profi ts (due to greed) while the fear of incurring a loss will see the same trader leaving poorly performing positions open in the hope that prices will move in the desired direction and reduce losses or even see them turn into profitable trades.

There is an old saying among traders that you should, “Let your profits run and cut your losses short”. In other words, if you have a profitable position, you should allow that trade to achieve its full potential, rather than closing it out at the first sign of (a small) profit. On the other hand, if you hold a position that is moving against you, you should move quickly to exit that position, before the loss becomes too great.

If you are managing your trades correctly, your average winning trade should be considerably larger than your average losing trade. Once you have the discipline to trade in this way, you should be able to achieve overall profitability even if only half of your trades are winners.

Many spread traders make the mistake of not closing poorly performing positions quickly enough. If you don’t cut losses you will turn your trade into a gamble where you believe that the loss that you have sustained so far will decrease and that the market will turn round in your favour. This is a losing strategy because even if you manage to make profits on most of your trades, the few ones which sustain losses can rapidly offset any profits you gain on your other trading positions if you allow your losses to accrue indefinitely. As humans we are by nature resistant to accept that we are wrong, even when we know the consequences and because of this some spread traders tend to keep running losses even when the odds keep mounting against them. In his efforts to be proven correct, eventually the loss will be such that it forces the spread better to close the spread trade due to insufficient available fund to keep running their position, or due to the fact that the spread trader ‘has had enough’.

One tool that makes it easier to cut losses is the stop-loss order. Once you have identified a price level that corresponds with the level of risk that you are willing to take on a particular trade, a stop-loss order can be placed at this level to automatically close out the trade. This removes the human element from the exit, reducing the risk that the emotion of hope will interfere with rational trading decisions.

On the other hand they also tend to take profits early – it is bad practice to jump on the first bit of profit particularly if you have already gone through a succession of losing trades. Cashing out quickly and exiting early due to fear or greed (making a fast buck) is a losing long term strategy. In this respect risk management mechanisms such as stops and limit orders help to ensure that your spread trades automatically close out or cash out at preset levels. Orders can also be set so as to enter a market when stock prices reach a pre-determined level for speculation.

It is important to understand that a stop-loss order simply provides a trigger point for the execution of an order. If a sell stop has been placed on a long position, the stop-loss will be activated if price trades at or below the nominated stop level. From time to time, this can result in trades being executed a price that is less favourable than the nominated stop-loss price. This is known as slippage.

  • Not understanding the instrument being traded

Being over-the-counter products, there are a great many differences in the specifications of contracts available as spreadbets. If you are trading these products, it is your responsibility to know what these product specifications are. For example, what exactly does 1 pip of this market represent. What are the trading hours?

Sometimes, it might be better to stick to spread bets based on markets that you are familiar with rather than venturing off into markets you don’t fully understand. Understand what moves the market you are trading and its normal day-to-day fluctuations. For instance, if you aren’t aware that a sudden rise in oil prices would put additional pressure on airlines and consequently their stock prices, you could be fighting a losing battle if you have a long position on British Airways. Having a good understanding of the market you are trading also helps you deciding on matters such as where to place stops and limit orders.

  • Using the wrong order type

Spread trading with real money should be viewed as a serious business. As such, you should take the time to ensure that you thoroughly understand the most basic tools of the business. Many spread traders have missed opportunities or closed out of trades at the wrong time simply by placing the wrong type of order.

At the very least, you should understand the following order types:

Market order: Used to execute a trade at the current market price.
Stop order: To exit a trade, place a stop order at a level that is worse than prices currently available in the market. On a long position, the stop-loss order to sell would be placed below current market prices. Conversely, on a short position, the stop-loss order to buy would be placed at a level above current market prices.
Limit order: To exit a trade, limit orders are placed at a level that is better than the current market price. When seeking to lock-in profits on an open long position, a limit order to sell would be placed at a level above current market prices. If seeking to lock-in profits on a short position, a limit order to buy would be placed at a level below current market prices.

  • Using an Inappropriate Strategy

A common mistake among spread traders involves using an inappropriate strategy, or worse still, having no trading strategy at all. Trading can be exciting but it can also be emotional and without a trading plan it is very easy to continue running losses or taking profits prematurely.

Using some type of strategy on a consistent basis, even a simple moving average cross-over system, provides a framework of discipline for the trader. This is generally going to deliver better results than a hap-hazard approach or the use of a constantly changing series of strategies.

Some care must be taken when selecting a strategy. It would be a mistake to attempt trading a strategy based on five minute charts if you are unable to access your trading platform for much of the trading day. Similarly, it would be a mistake to use a strategy based on monthly charts if your trading horizon is measured in days or weeks.

People tend to hold a belief that a more complex system must be a better system. This is especially true among certain groups of traders. They develop systems that employ huge numbers of inputs and require extremely complex calculations and algorithms. They often produce charts that are so heavily covered in indicators that it becomes difficult to see the price action. While some of these complex systems certainly can be profitable, the more inputs and calculations they require, the more potential there is for something to go wrong.

In many ways, a simple strategy is often better (and easier to follow with confidence) than a more complex system. Most sharp traders agree to cutting losses early while letting profits run is a sensible path to follow. Stops and limit orders help in this regard as this eliminates the risk of impulsive trading while automating the trade management.

One of the tools employed by many strategies is the short trade. This is where a trader sells a security that they don’t currently hold in anticipation of buying it back again at a lower price in the future. While it can be argued there is little diff erence between taking a long position or a short position, the short position may not be appropriate for a highly conservative trader.

In theory, a short position holds much greater risk than a long position. This is because of the difference in the maximum potential adverse excursion for each type of trade. With a long position in equities, the worst possible move would be for the equity to fall to zero and become worthless. For a short position, where losses will mount as prices rise, the maximum adverse excursion is theoretically unlimited. While holding a short position on a security with a skyrocketing price is unlikely, it is a possibility. Accordingly, it might be considered a mistake for a highly conservative trader to trade on the short side, especially without a stop loss order in place.

  • Not taking responsibility for trades

While most traders keep a keen eye on their open positions, there are those that make the mistake of not doing so. By frequently checking on your open positions you will know what your overall exposure to the market is and whether you are in profit or loss.

In addition to errors, some traders simply forget that they have placed certain orders, or through unfamiliarity with the platform, fi nd that they have accidentally placed orders without intending to do so. It is best to detect these mistakes as quickly as possible by monitoring your open positions.

Mistakes made when entering trades are more common that you might think. Traders frequently hit buy instead of sell (& vice versa) or enter the wrong quantity or even the wrong ticker symbol. These are simple mistakes that are often put down to having a “fat finger”. However, if you take your trading seriously, you should ensure that you exercise the appropriate level of care.

  • Trading for the wrong reasons.

Most people undertake trading with the goal of making a profit. However, there are some people that participate in the market for entertainment, either consciously or unconsciously. If you are in the market in order to make a profit, it is important that you approach your trading in a serious, business-like manner. People that trade for entertainment, or to impress their friends, will be lucky to break even, let alone make a profit.

Be careful not to make the mistake of viewing yourself as a serious trader if, in fact, you are just seeking entertainment.

  • Over-Trading

Another important mistake to avoid is the temptation to over-trade. This is a greater risk for traders that are not following a pre-determined strategy. Sometimes, choosing to sit on the sidelines until a clear trend emerges is in itself a valid strategy.

Spread traders should also avoid the mistake of consistently trading fully leveraged positions just because they have margin available. Each trade should be considered on its own merits and within predetermined risk parameters.

To avoid the possibility of being exposed to such a dire (if unlikely) outcome, it is important that you do not trade with money that you cannot afford to lose.

  • Undercapitalisation

Although you typically only need a small percentage amount (normally 1% to 10% of the total market value) to open a spread betting trade, movements in the stock market can generate not only gains, but also losses in excess of your initial deposit.

When I was first introduced to the world of spread trading, I only committed a small amount of capital to the higher risks of spread betting, but I was always stopped out, or margin calls forced a close of the position, only to then see the resumption of the trend you’re no longer a part of. I’ve now committed a much higher proportion of capital, but crucially kept bet sizes the same, and therefore given myself the buffer I need. I have done far better, and dramatically reduced my overall risk as a result. Ironically I was told all this by David Jones on a spread bet course (with CMC at the time, but he’s now at IG) many years ago, but it took me a long time to learn the lesson myself.

  • Lack of Diversification

Sometimes you just want to put all your money on a single stock which you feel is likely to soar, but placing all your eggs in one basket and not spreading your monies across multiple markets is a common mistake. Not diversifying only means that if something were to happen to that stock you are invested in, it will have a severe impact on your trading position, particularly if the market in the event of the market gapping. Make sure to learn and understand everything there is to understand about your chosen market because most markets are inter-connected these days and this correlation makes it really hard to get a good level of diversification. For instance, rising energy prices can often lead to a fall in the stock price of airline stocks. In such a case, your trading positions aren’t really diversified even in cases where these relationships are inverted. Diversification helps to protect your account from any particular event, like a sudden hike in energy prices or a crashing banking sector which should have a lower overall effect. Diversification also helps to minimise account fluctuations – so when one of your trading positions is underwater another may be doing well which will help to protect your account from market events.

My last word on the subject, investing in spread betting substantially is not for the faint hearted IMO. and congratulations on your success.  I’ve found that the only answer is to be prepared for bad days, to make hay while the sun shines and remind yourself that profits are only real when they’re in the bank! Give yourself as much a head start as possible with analysis, both market and technical, and try not to find yourself too exposed on days when everything seems to be creashing! Cash and hedging using profits might not seem very exciting until there’s a shock in the market.  I also think it’s important not to make rash decisions based on what the market is doing, not to panic buy on a +150 day when there’s no news as well to avoid selling all shares when the market begins to panic. It’s possible to “do too much”, when you’d make more money by relaxing a bit and taking a calm approach =)

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