Having been a trader for more than 20 years I am fond of thinking that I've "seen it all." While I'm sure this isn't true, it does seem like it at times. Much of what I have seen (and experienced, sadly) is chronicled in the books The Four Biggest Mistakes in Option Trading and The Four Biggest Mistakes in Futures Trading. The most amazing aspect of all of this is the fact that so many traders make so many of the same mistakes again and again, and then after they're done, another wave of traders come along and take their place, making the same mistakes as the traders before them. And although these mistakes are well documented and this knowledge is well circulated, it doesn't seem to make the least bit of difference among traders en masse. How can this be so? Quite simply, it's human nature.

One of the most oft-repeated mantras in the trading world is that it all revolves around "fear and greed." And even though we know at times that we are acting solely out of fear (of losing more money on a given trade, for example) or greed (putting way too much capital into a given trade because we're "sure" its going to be a big winner), it can almost always be rationalized in our minds as "the prudent thing to do under the circumstances."

Consider the following scenario: you've had four losing trades in a row and are down 6% this month. You enter into a fifth trade - based on some sound basis - and it too starts to go south. Now your hard and fast preset rule has always been to give each trade let's say 7% on the downside before you stop your loss. However, this time you start to feel the pain of yet another losing trade creeping up your spine. Let's face it, it feels bad to lose money. It feels really bad to lose money four times in a row. And it really feels bad to lose money four times in a row and then have your next trade go immediately into the red. The natural reaction is to want to "play defense." Questions start to enter your mind. Does my approach not work anymore? Should I be doing something different? Should I just get out and wait for things to "settle down"? And so on and so forth. And here is really where one gets down to the nitty-gritty, deep down heart of trading.

The voice on one shoulder is telling you simply to "make the pain stop." And it is a powerful, persuasive argument. Heck, you didn't get into trading to lose a lot of money and to feel bad and to beat yourself up and question yourself. Why not stop for a while and make all of that go away? Meanwhile the voice on the other shoulder calmly reminds you that your hard and fast rule is to give every trade 7% on the downside before you stop your loss. But the first voice counters, "what does he know, he's lost money four times in a row"? And so the battle rages in our head.

If you've read enough books and been around the business long enough, you know that the "right" thing to do it to adhere to your 7% stop-loss rule. Period. End of story. Yet time and time and time again, that first voice ends up persuading us to "cut and run." And the bottom line is that this is absolutely a "no win" action to take. Allow me to explain.

Let's say you forsake your 7% rule and cut your loss immediately. One of two things is going to happen. Murphy's Law being what it is, on most occasions (or so it seems) the stock or option or futures contract or mutual fund that you just sold, will almost immediately turn tail within moments of your exiting, and begin screaming sharply in the direction you thought it was going in the first place. And you are left trying to decide whether or not to pull the trigger and get back in at a much higher price than that at which you sold. By violating your rule in this case, you have taken yourself out of the fire and placed yourself directly into the frying pan, whereby you now have to make another subjective decision regarding what to do next. And will that decision be right or wrong? And what will you do if it is wrong?

On the flip side of the coin, pity the trader who cuts his loss subjectively rather than following his preset rule, and turns out to be right in doing so. The problem here is that he has done himself a short-term favor but sets himself up for a long-term problem. In this particular case he has saved himself some money. But what about next time? And the time after that. From this day forward, anytime he feels the urge to forsake his preset stop-loss rule, he has in his memory banks a crystal clear vision of how good it felt that one time to "stop the pain," and also how he saved himself more money. In the end it simply becomes easier and easier to violate his own trading rules.

And so it goes, and so it goes. Traders made this type of mistake 100 years ago, traders are making this type of mistake today and traders will still be making this type of mistake 100 years from now. The good news is that as individuals we don't have to worry about what all other traders are doing. We can focus solely on our own actions and fight against trading mistakes.

Assuming that you have a sound approach to picking trades in the first place, if you have a particular trading rule - again let's use the example of a 7% stop-loss order on individual stocks - do you suppose you will be better off in the long run if you:

a) Follow your rule on each and every single trade, or
b) Follow your rule sometimes but not on other times, depending on "current circumstances."

I encourage you to think long and hard about your answer. It may spell the difference between your long-term success or failure.

Jay Kaeppel
Staff Writer and Author of Seasonal Stock Market Trends
Optionetics.com ~ Your Options Education Site

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