November/December 1998
Trading is a risky business, but it can be less risky if you learn from these common trading pitfalls.
By Matt Levine
Matt Levine, a copper and brass broker as well as a specialist in risk management and options trading, is vice president of Leonard Levine Metals Corp. (Northbrook, Ill.). He has been a member of the Chicago Mercantile Exchange since 1984 and is a past member of the Chicago Board of Trade.
I love trading stories. Guys who put their companies on the line with rash speculations. Millions or billions of dollars made and lost. And the losses are most interesting. In recent years, we’ve seen banks fail and companies out billions from trading losses. Were these just bad luck, examples of “I would have been OK, but the market went the wrong way”?
I think not. These were compounded losses due to simple trading mistakes. Really simple. The kind every professional trader knows are wrong.
Maybe I like these trading stories because I can see in them mistakes I’ve made. Mine didn’t get out of hand like Hamanaka’s monumental copper losses, but they were no less foolish. Traders learn from mistakes. There’s nothing like a five- or six-figure loss to keep your attention and teach you a lesson. Some of these guys talk in terms of that Mercedes they dropped today or that ranch in Aspen that’s going back on the market. The lessons I learned while on the floor of the Chicago Mercantile Exchange are more related to a bicycle or a small sofa. But the lesson’s imprint is the same.
So, you don’t have a couple of hundred Gs to lose for your trading education? What, not even $10,000? Well, I think I can help. I’ll tell you the most common trading mistakes. If you avoid them, you’ll save a fortune. And just so you don’t forget, I’ve included a chart of rules to post near your desk (see “The 12 Trading Rules” on page 74).
Look at it every time you trade. Look at it every time you get the urge to go against your better instincts. Look at it whenever you say, “I know it’s a mistake, but …”
I like to call these mistakes “hope trades.” That’s because hope grows more desperate as a trader’s position disintegrates. Then a trader starts saying things like “I hope I make a lot of money. I hope I break even. I hope I have enough money to cover my losses. I hope I don’t lose everything. I hope my wife doesn’t kill me.”
I hope you learn from these trading mistakes as I have.
Mistake #1—Limiting Your Profits But Not Your Losses
I told a client that I was writing this article and he said, “You’re going to use my story, aren’t you? Well, if you do, I want royalties!”
I offered to pay him if he allowed me to use his name. Fortunately, this trader has avoided Mistake #12—he didn’t let his mistakes distract him—so his story appears below, without attribution.
Copper stood at $1.315 on Comex. My customer wanted to close an open order at $1.32. That half a cent per pound difference would have meant an additional profit of $200 on a truckload of copper. When copper reached $1.318, I called him. But he remained firm—he wanted $1.32. The Sumitomo debacle subsequently caused the overextended market to freefall, and he closed his position well below $1.
The little solace I can offer my customer is that he’s in good company. He has committed the most common trading mistake. The most he could have made on his position was an additional $200, yet he risked what turned out to be thousands.
Let’s put this in Las Vegas terms: You walk up to a table—if you win, you get $1, but if you lose, you’ll owe anywhere from one to 60 times your bet (in reality, the loss could be more). The odds are as bad as 1:60. If you’re smart, you’ll walk away from the table even before your drink arrives. Yet, you’d be surprised how many people are willing to take this bet with their sales pricing.
Mistake #2—“I’ll Get Out When I Get Even”
This is an ego thing. Traders often don’t want to admit they’re wrong. Once the trade disintegrates, this is often the statement that prevails. My customers rationalize this by telling me how much money they have in the load or how much the material cost to process and ship. They say they can afford to hold the material until they get their price. This is irrelevant. What is relevant is the price you can get today. Not where the price may be later.
I know scrap executives who refuse to sell material for less than their purchase price. They’ll hold material at a huge loss and play the hope game. Eventually they’ll be right. Maybe it’ll take six months, maybe five years, but they will sell at a profit. That isn’t business. It’s ego. Even the best traders are right less than 50 percent of the time. The cost of capital, warehouse space, insurance, theft, and aggravation alone make this a silly strategy.
Mistake #3—Doubling Down
When hope and denial reach their pinnacle, this flawed logic gains credence. I’ve made this mistake trading so many times, I’ve lost count. I first tried it with stock options when I was 22 years old and promptly lost 15 percent of my yearly salary (albeit a small salary). I also lost sleep (I hadn’t learned Mistake #12—not to be distracted by my mistakes) and can still remember the pain.
Doubling down is simple. If you made a purchase at $1 because the stock or commodity looked good, then the deal looks even better at 90 cents. You buy more thinking how much more money you’ll make when the item goes up in price. At 80 cents, it’s a steal. You buy more. At 70 cents, well, I think you get the idea. Soon, you’ll be rationalizing the trade by saying you’re lowering the break-even point. You walk right into Mistake #2. At 60 cents, I promise that fear will set in and you’ll hope the price will get back to your break-even point.
Again, ego takes the place of logic. Hey, the market is moving against you. You’re wrong, but you refuse to believe it. What was a small loss can become a huge one as your position multiplies. You’ve made a mistake of not setting your downside target because greed from a potential profit blinded your logic. Now, your hole is deeper and harder to climb out of.
Mistake #4—Picking Tops and Bottoms
A wise investor once said, “Wall Street is littered with the graves of investors who were right too soon.” Too many traders try to out-guess the market. And the market never guesses, it simply moves.
On June 5, the stock of Amazon.com was priced at just under $44 a share. The company had no earnings and was selling at an astronomical price-to-earnings multiple. By June 24, its stock more than doubled, surpassing $100 a share. Traders “went short” the stock in expectation that the price would drop. Two weeks later, the stock reached $1433/4. Those who went short were creamed. Eventually, the stock dropped, but not before most shorts lost big. I’d wager that the last buyers of the stock, those who bought the all-time high price, were traders covering shorts.
A true trader rarely establishes positions against the market trend. He may look for a change in trend but won’t jump in until the change takes place. If he does try to pick a top, he’ll always try to avoid Mistake #1 and limit his losses.
Mistake #5—“It Can’t Happen”
It can happen, and it will happen. Maybe not this time, but eventually.
When I worked for an international bank, I looked at the Treasury bond position of a trader. He stood to make $500,000 for the bank if the T-bond remained steady. But he’d lose at least $4 million to $5 million if interest rates rose. His risk-to-reward ratio was terrible. I asked him why he’d take such a risk, betting against rising rates. He said it wasn’t a risky position because interest rates could not rise. I visited the treasurer of the branch, the trader was fired, his position was liquidated, rates rose, and the bank avoided disaster.
Did I know this would happen? No, but the trader’s position was based on ego, not logic. If he wasn’t wrong this time, he would be in the future.
Mistake #6—“I’ll Buy Aluminum Because Copper Is Strong”
In this case, you’re comparing apples and oranges. But you’d be surprised how many traders follow this flawed logic.
When I traded foreign currencies, the Swiss franc was gaining on the dollar. At the same time, the Deutsche mark was steady. I had to buy the D-mark, I thought, because the Swissie kept gaining. After all, if the dollar was falling against the Swiss franc, it would have to fall against the D-mark. The market didn’t realize this, but I did.
What happened? The D-mark fell and I lost money, while those who’d gone long on Swiss francs added to their profits. I should’ve bought the D-mark for its merits, not for the merits of the Swiss franc. The currencies may be cousins, but they’re not identical twins. They move on different fundamental and technical factors.
A trader will buy strength, not a similar commodity’s weakness relative to the strength. Watch copper to decide when to buy or sell copper. Watch aluminum to decide when to buy or sell aluminum. You can try to prove me wrong. Occasionally, you’ll be right, but I guarantee the odds are in my favor.
Mistake #7—“I Don’t Have Anything in It”
I’ve lost count of how many times I’ve heard this in the scrap business. Hey, if the price of something you own goes from $1 to 50 cents, it doesn’t matter how much you paid for it. You lost 50 cents. To say you didn’t pay much for the material is irrelevant. Protect your profit the same way you limit your losses. Next thing you know, you’ll want to get out at what you paid for it (see Mistake #2).
Mistake #8 —“I Got a Tip”
A friend tells you to buy a stock at $20. “It’s going to $30,” he says. You buy the stock and it drops to $10. You call your so-called friend. “Oh,” he says, “do you still own that stock? I sold it at $18.”
Tips are rarely worthwhile. Anybody can find a reason to buy or sell at any time. Remember, every time you buy an item, someone has to sell it to you. They obviously feel differently about the price than you do. Of course, they may be picking a top, doubling down, or establishing a long-term trade. If you do take a tip, avoid Mistake #1. Know what you’re willing to risk when you take the position.
Mistake #9—“I Gotta Get In”
You like a stock and start to watch it. It has a chance of doubling, you think. The price is $10 and jumps to $12. You raise your eyebrows. Then, it rises from $12 to $15. You get itchy. You think about how much money you could’ve made. From $15, it rockets to $20. You can’t take it. You buy at $22.
This scenario plays on the emotions of the trader. He chases the trade. Perhaps he’s right, but at $22 he’s taking more risk than he would have if he’d bought at $10. His rationale for buying is flawed. Though the momentum of the trade is clearly in his favor, he has bought for fear of missing out on the profit. Fear isn’t a reason to establish a trade. An experienced trader knows he’ll have more opportunities. He can’t catch every one.
Mistake #10—“This Is a Long-Term Trade”
This is simply rationalization, usually after making Mistake #1. I never hear this comment when the market is in the trader’s favor. This is commonly a way for the trader to accept and keep his losing position.
Mistake #11—“I Sold the Easy Side First”
This mistake has to do with a two-sided transaction. Buying scrap from an industrial account and selling it to a mill would constitute a two-sided transaction—the buy side and the sell side. The problem is with the liquidity of each side, or the ease of making each side of the transaction.
I had a great trade going. In a fairly complex transaction, I bought Japanese yen options and hedged with futures. The trade had little price risk in that any price movement had little effect on my position. The trade was a good one, and I decided to realize my profit. Or so I thought.
Getting in and out of the futures was much easier, and my mistake was that I exited the futures first. Now I had no hedge, making my options position very price-sensitive. Of course, the market started moving against my trade. As I placed the order to sell the options, the bid dropped. I lowered my offer price, and the bid dropped again. I was up against one trader who knew I was selling. Every time I lowered my offer, he lowered his bid. I finally stopped playing games and sold to him at his bid price. In the process, I gave up all my profits.
In scrap terms, the parallel is taking a position with a mill and being uncertain of buying material to cover the order. I’ve seen processors pay way over the market to fill an order. If the material isn’t there and yet the order has to be filled, any price asked for the material is fair. If the processor had bought the difficult-to-find material first, then sold it to the mill with an easier-to-get order, the risk would’ve been greatly reduced.
The lesson is this: Be aware of which side of the transaction is more difficult to establish—that is, less liquid. Never trade in or out of the easier side first.
Mistake #12—Looking Back at Your Past Trades
Most of my friends invest in stocks. They don’t open the Wall Street Journal or the business section of the paper regularly to look at their stock holdings. But, invariably, as soon as they sell a stock, watching the price becomes an everyday ritual.
Nothing can be gained from fixating on a closed trade. If you made one of the above mistakes, recognize it, learn from it, and try not to do it again. Too many traders get blinded by obsessing on mistakes or missed opportunities. Focus your attention on future opportunities, not lost chances.
* * *
The trading floor smells like a locker room, sounds like a sold-out football game, and looks like a beehive. In addition to these distractions, traders are confronted by volatile markets and their own emotions. Still, many are successful.
Perhaps they had a mentor. Perhaps they learned through hard knocks. Such learning takes years. The best traders spend these years learning how to survive. Survival means avoiding pitfalls and the unthinkable—running out of money before you learn how not to lose it. It you study these 12 mistakes and learn to recognize them in your trading, you’ll not join my database of loser stories or end up like this guy:
“I’m working to earn enough money for another grubstake,” he said. “I made more than $50,000 in my first month of trading. I can’t wait to go back on the floor.”
“What happened?” I asked.
“I got caught in this trade,” he said, “and I couldn’t get out. I kept adding to my position. I didn’t think it could go lower. But every day I lost more money. I had to borrow from my parents and friends to pay my debts. And within two months of when I finally took my loss, the market turned around. I would’ve cleaned up.”
“Too bad,” I said. “How much do I owe you?”
“The fare is $5,” said the cabbie.
The 12 Trading Rules
This handy list of trading rules—based on the most common trading mistakes—can help you trade more prudently … maybe. Post this list in an obvious place, and good luck.
Rule #1: Set your downside risk.
Rule #2: Don’t limit your profits.
Rule #3: Don’t double down.
Rule #4: Don’t pick tops or bottoms.
Rule #5: It can happen.
Rule #6: Don’t let profits disappear.
Rule #7: Buy strength, sell weakness.
Rule #8: Don’t rationalize bad trades.
Rule #9: Avoid trading tips.
Rule #10: Always trade the illiquid side of a transaction first.
Rule #11: Don’t chase trades.
Rule #12: Learn from mistakes, but don’t be distracted by them. •
Trading is a risky business, but it can be less risky if you learn from these common trading pitfalls.