Here is the third part of our 7 part series titled “The 7 Deadly Financial Spread Betting Mistakes”. Today we will discuss the third of the 7 financial spread betting mistakes that financial traders make:
Mistake # 3 Trading against the trend
You should never trade against the trend but should always follow the trend. There are several reasons for this. The first reason is that the price is the only instrument that takes into account all the knowledge everybody has about that particular commodity. If the price is going up then there is a reason for that. We do not need to know the reason, we only have to get on board and stay with the trend until it ends.
Conversely, if the price is going down then there is a reason for that as well. Why would we want to get on the wrong side of the prevailing trend? Traders want to be right and they want to say “I got in right at the bottom, look how smart I am”, not realising that those bottom few points that traders try to pick are the most expensive few points in history.
If you think about it, how likely is it that you are able to pick a point near a reversal in price and that the price is just going to stop and then start moving the other way? It’s not really very likely. Far more likely is that the price will continue to move in the same direction that it is already going.
The example I like to use is that counter trend trading is like jumping in front of a fast moving train and hoping that it stops right in front of you, turns around and then starts going in the opposite direction. Why not just jump on the train in the direction it’s already going and stay on board for the duration of the journey (the trend) and then get off the train (exit the trade) when the train finally reaches its destination and starts to turn back?
This is the optimum approach and affords easy risk control, because it will soon become obvious if the trend is not going to continue and you can then exit the trade with a small loss, leaving your trading capital intact and you ready to take the next good trading opportunity that comes along.
If you are counter trend trading and are looking for the top or bottom of the market and you decide for example that Gold has dropped to $850 and you are sure this is the bottom and it has to go higher (after all only a week ago it was at $900!) you buy Gold at $850 only for it to fall to $830. If it was a good buy at $850 it must be an even better buy at $850, so you decide to open a new trade at $830 (after all this is giving you an average price of $840 which must be good!). This process is known as averaging down. We’ll talk about this in part 4 of The 7 Deadly Financial Spread Betting Mistakes.
Meanwhile, Gold falls further still. Now you have a big loss on your hands and Gold stands at $820. Using the same logic as before, you borrow some money and buy more Gold at $820. Again you are wrong and Gold falls further to $790 and therefore wipes out your account. This kind of thinking is commonplace and is the cause of most people losing all their money because people buy into the myth that things return to normal. Sometimes they do but many times they do not.
The fact remains that if you were trend following, i.e. trading in the direction of the trend then you would not have been in this position in the first place as you would have exited your trade shortly after it moved against you, taking a small loss. You would also not have averaged down (added extra trades to your original position), as this would be taking trades against the trend. Therefore you would have just taken 1 small loss, instead of several large losses, and lived to fight another day.
A very popular trading theory is buying on dips and selling rallies. This is counter trend and is a mistake. Testing this theory out over a long period of data proves that this is a losing strategy. The reason for this is that if the market falls and you are looking to buy on a dip, how do you know that this is not the start of a trend reversal? You could buy on the dip only for the market to continue to go against you. The same is true for selling rallies.
The rule here is that you must trade with the trend and therefore you must buy strength and sell weakness. Therefore you should never buy on dips or sell rallies but should wait for the momentum of the market to go your way before entering. Counter trend trading is going against the market and is best avoided.
Longevity in trading is the key as long as you have a system that has a positive expectancy, or an edge. The LS Trader system is such a trading system as it has a positive expectancy and therefore an edge. The longer you stay in the game, the more chance that edge has of coming to the fore. This leads to long term profits, which is what all traders are after.
Part 4 of the 7 deadly financial spread betting mistakes will be published here in the next few days.