The Temptations of Spread Betting

Just about everyone knows the grisly statistics about options trading: 90% of all naked option players (no, that doesn't mean they trade in the buff, only that they buy uncovered puts or calls) end up losing money. But hardly anyone knows the equally grisly statistics about equity trading: 80% of all stock investors end up losing money.

Trading Mistakes - The main reason Bob trades online is because his dumb mistakes remain anonymous

But how can that be, you ask? Over time, the stock market is a sure thing, a guaranteed way to make money. It's so easy. All you have to do is buy good stocks and hold them. Everybody says this, pundits, brokers, financial advisors, the media, the historical record itself. No one who simply bought and held the Dow Jones Industrial Average or the S&P 500 has ever lost money over a 20-year time span. Right? Yes, right. Now go find me someone who bought and held for 20-years. You should be able to find a few, about 20% to be precise. The other 80% lose money.

How does this happen? A couple of ways. Primarily, it happens because no matter how resolute people think they are about buying and holding, they usually fall into the same old emotional pattern of buying high and selling low. Investors are human beings. Human beings naturally want to be in the winning camp, and human beings naturally seek to avoid pain. When things are most euphoric in the investment world, at the top of a long bull market, these human beings are in there buying. And when things are most painful, at the end of bear market, these human beings are in there selling. In fact, it's usually the final capitulation of the last remaining "holders" that sets up the end of the bear market and the start of a new bull market. As Sy Harding says in his excellent book "Riding The Bear," while people may promise themselves at the top of bull markets that this time they'll behave differently, "no such creature as a buy and hold investor ever emerged from the other side of the subsequent bear market." Statistics compiled by Ned Davis Research back up Harding's assertion. Every time the market declines more than 10% (and "real" bear markets don't even officially begin until the decline is 20%), mutual funds experience net outflows of investor money. Fear is a stronger emotion than greed. Most bear markets last for months (the norm), or even years (both the 1929 and 1966 bear markets), and one can see how the torture of losing money week after week, month after month, would wear down even the most determined buy and holder. But the average investor's pain threshold is a lot lower than that. The research shows that It doesn't matter if the bear market lasts less than 3 months (like the 1990 bear) or less than 3 days (like the 1987 bear). People will still sell out, usually at the very bottom, and almost always at a loss.

So THAT is how it happens. And the only way to avoid it is to avoid owning stocks during bear markets. If you try to ride them out, odds are you'll fail. And if you believe that we are in a New Era, and that bear markets are a thing of the past, your next of kin will have my sympathies.

But people lose money in other ways, too, even during the strongest of bull markets. Let's look at some of the more common trading mistakes to which people are prone. Many of them are related, part and parcel of the same refusal to pay proper attention to risk management. If you recognize your own actions in some of these, join the club. Over the years, I've committed every sin on the list at least once. Still do on occasion.

-- Spread Betting Risks: Letting small losses turn into large losses.

A whole myriad of mistakes accompany this one. Refusing to take a loss at all. Overbetting. Catching falling knives. Averaging down. Etc., etc.. At root, it's probably because the average investor pays little mind to risk management. In a way, it's understandable. The majority of those in the market today have only come into the market during the last 5 to 7 years. They have never really experienced a serious bear market. The only investing world they know is that of an ongoing bull market, where it's ALWAYS okay to buy the dips, where a stock that craters ALWAYS comes back. But SOMEBODY bought UBid at 121. And SOMEBODY bought eBay at 234. I hope it wasn't you. You should only be buying stocks that are in an ongoing uptrend (hopefully not TOO far along however), or those that are bottoming out following a stiff correction. In other words, when you buy a stock it should be with the expectation that it will go up (otherwise, why buy it?). If it goes down instead, you've made a mistake in your analysis. Either you're early, or just plain wrong. It amounts to the same thing. There is no shame in being wrong, only in STAYING wrong. If a stock does not quickly begin to move in the direction you envisioned when you purchased it, you should begin to question your reasons for owning it and you should immediately put it on a short leash. If it doesn't turn in relatively quick fashion, get rid of it. You can always go back in later, when it really turns. This goes to the heart of the familiar adage: let winners run, cut losers short. Nothing will eat into your performance more than carrying a bunch of dogs and their attendant fleas, both in terms of actual losses and in terms of dead, or underperforming, money.

-- Spread Betting Risks: Refusing to take a loss at all.

I simply don't understand the way some people think. From whence came the idiotic notion that a loss "on paper" isn't a "real" loss until you actually sell the stock? Or that a profit isn't a profit until the stock is sold and the money is in the bank? Nonsense. Your stock and your portfolio is worth whatever you can sell it for, at the market, right at this moment. No more. No less. People are reluctant to sell a loser for a variety of reasons. For some it's an ego/pride thing, an inability to admit they've made a mistake. That is false pride, and it's faulty thinking. Your refusal to acknowledge a loss doesn't make it any less real. Hoping and waiting for a loser to come back and save your fragile pride is dumb. Your loser may NOT come back. And even if it does, a stock that is down 50% has to put up a 100% gain just to get back to breakeven. Losses are a cost of doing business, a part of the game. If you never have losses, then you are not trading properly. Most pros have three losers for every winner. They make money by keeping the losses small and letting the profits build. You should be almost happy to take a loss. It means that you have jettisoned an underachiever stock and have freed up that dead money to put to better use elsewhere. Take your losses ruthlessly, put them out of mind and don't look back, and turn your attention to your next trade.

-- Spread Betting Risks: Overbetting.

This gets into the realm of money management. Diversification, the process of spreading your investment capital around in different assets and sectors to feather the vagaries of the market, has gotten a bit of a bum rap lately. Some of the New Paradigm folks think the concept is "old fashioned." These tend to be the same people who have every last dime in a handful of internet stocks. That's not investing, or even trading. It's gambling.

Here's what one investor had to say about the demise of his equity in PVCS stock an AIM listed company: Yes I am a shareholder licking my wounds thanks to the IC tipping these shares at 60p+ in Febrary of 2011. Am I pleased I run a diversified portfolio, you bet I am. I have been investing in shares since 1964 and this is the second time this has happened to me. The other company was Scanro, during 1980's, a company which made world class surfboards. A very large company in the USA went into administration who also made surfboards and the administrator sold off their stock very cheaply which meant nobody purchased Scanro's surfboards. Do you see the comparison?

Preservation of capital is paramount. If you run out of chips, game over man. You may feel a bit envious the day your neighbor, who has put everything he owns into Zowie.com parks his new Mercedes in the driveway next door, but you'll feel a lot better the day the repo man comes with the tow truck to take it back. Most professionals will allocate no more than 2-5% of their total investment capital to any one position. Ten percent should be your absolute max. One more thing. I've checked the U.S. Constitution and the Bill of Rights, and nowhere in either of them does it say that you have to have ALL of your money in the stock market ALL of the time. Money management also pertains to your total investment posture. Even when your analysis is overwhelmingly bullish, it never hurts to have at least some cash on hand, earning its 5% in the money market. You'll need it when you see that next "can't miss" stock but don't want to sell any of your other "can't miss" stocks to raise the money to buy it. Your exposure should be consistent with your overall market analysis. As the market becomes more overbought, overextended, and overvalued, your cash level should rise accordingly. Then as the market gets more oversold and undervalued, you can raise your market exposure accordingly. Being ALL in the market or ALL out of the market sounds like a good idea, and it may work out wonderfully on paper, but it rarely plays out so smoothly in real life and real investing. But you should still employ a sliding scale of exposure, based on your market analysis.

-- Spread Betting Risks: Bottom fishing/Catching falling knives.

Many of the daily e-mails I get are of the following type: "Nick, Zowie.com is down 23 points today. Time to buy?!!!" My answer is almost always the same. "Put your pants on, Spartacus. No!" Don't ANTICIPATE bottoms. It's tempting to try to pinpoint an exact low, especially if you're working with indictors like Fibonacci fan and time lines, cycle studies, regression channels, even plain old lateral support points. But it's almost always better to let the stock find its bottom on it's own, and then start to nibble. Just because a stock is down big doesn't mean it can't go down even bigger. In fact, a major multipoint drop is often just the beginning of a larger decline. It's always satisfying to catch an exact low tick, but when it happens it's usually by accident. Let stocks and markets bottom and top on their own and limit your efforts to recognizing the fact "soon enough." Nobody, and I mean nobody, can consistently nail the bottom tick or top tick. Those who try usually get burned.

-- Spread Betting Risks: Averaging down.

Don't do it. For one thing, you shouldn't even have the opportunity, because you should have sold that dog before it got to the level where averaging down is tempting. The pros average UP, not down; they got to be pros because they added to winners, not losers. And speaking of averaging UP, there's a right way to do it. And doubling your position is not it. Rather, you should add 1/2 your original stake. If other words, if you already own 100 shares and want to bolster your position, you buy 50 shares. If you later decide to add more, you add 25 shares, etc. Why you should do it this way is too long to go into here, but that's the way the math works out best for you.

-- Spread Betting Risks: Shorting bulls and buying bears.

Yes, there are stocks that will go up in bear markets and stocks that will go down in bull markets, but it's usually not worth the effort to hunt for them. The vast majority of stocks, some 80+%, will go with the market flow. And so should you. It doesn't make sense to counter trade the prevailing market trend. If you're worried about a short term pullback, simply cut back on your trading, take a few profits, and build up your stash of cash. Let that money earn its 5% in the money market until the squall has passed.

-- Spread Betting Risks: Confusing the company with its stock.

There are some fine companies with mediocre stocks, and some mediocre companies with fine stocks. Try not to confuse the two. This is, at heart, a fundamental analysis versus technical analysis issue. Some stocks simply have excellent trading characteristics while others don't. Maybe it's a matter of liquidity, or a fanatical message board following, or a daytrading clientele, or whatever. Take Amazon.com for example. Is the company a good one? Who knows? Not me. But the stock is. I wouldn't want to have to hold it for 20 years, but I sure don't mind trading it a few days at a time, the "right" days. That sucker moves. Baby Bells are at the other end of the spectrum. Fine companies for the most part. Wouldn't mind owning one for 20 years. But you have to pick your spots when you go to trade them, because a measly 3 point move in a single session is huge for a Baby Bell. Also remember this: even the stock of a great company can go through a bad patch. IBM is a great company today, with its stock selling at 124, and it was a great company five years ago, when its stock was selling at 13.

-- Spread Betting Risks: Falling in love with a "story."

This is related to confusing the company with its stock. There are a lot of intriguing "stories" out there, but they don't always translate into instant riches. Iomega was such a "story" stock. The story was that the company's Zip drive was going to replace the floppy in the world's computers. The stock ran straight up to the sky to wait for the story to come true. And for the most part, IOM's story DID come true (many stories don't, witness the Y2K stocks), but the stock gave back most of its gains anyway. Turns out it wasn't that much of a story after all. In other cases, the story comes true but the stock you've bet on isn't the story teller. Witness the laser vision "story." A number of companies were hyped as the category killer, but only one, VISX, made its stockholders real money. And how about satellite communications? Great story, eh? Tell it to those who loaded up on Iridium's stock.

-- Spread Betting Risks: Following the leader.

Just as money tends to flow into last year's top mutual fund (sure to be next year's underachiever), people tend to chase the high flying momentum MO-MO stocks, succumbing to the buzz and getting in AFTER the stock has already jumped 80% and inevitably just before it drops 60% as the early buyers take their profits by selling their shares to the "greater fool," you. Yes, you can make a quick buck chasing momentum, but you can lose it even quicker. You can never be sure there's a greater fool coming in after you, and that could make you the "greatest fool."

-- Spread Betting Risks: Buying IPOs.

An astonishing number of people don't understand how IPOs work. YOU are not really buying an IPO when you buy the stock on the first day of public trading when it opens at $75. Those who REALLY bought the IPO were those who got their shares for $10, well before the public trading began. For the most part, only institutions or megamillionaire private investors have access to IPOs. There have been a few exceptions, but it's almost universally dumb to buy a hot IPO on its first day of public trading. As for those few times when the average investor IS offered shares in an IPO before public trading begins, my advice is to pass. My rule of thumb on IPOs is: If you want it, you can't get it, and if you can get it, you don't want it.

-- Spread Betting Risks: Finding the Holy Grail.

Technicians regularly fall into periods where they tend to favor one or two indicators over all others. No harm in that, so long as the favored indicators are working, and keep on working. But the analyst should always be aware of the fact that as market conditions change, so will the efficacy of their indicators. Indicators that work in one type of market may lead you badly astray in another. You have to be aware of what's working now and what's not, and be ready to shift when conditions shift. There is no Holy Grail indicator that works all the time and in all markets. If you think you've found it, get ready to lose money. Instead, take your trading signals from the "accumulation of evidence" among ALL of your indicators, not just one.

-- Spread Betting Risks: Overtrading.

The Picks Port commits this sin on a regular basis, but that's mostly because of the nature of the beast. I have to be more short term oriented than I'd prefer to be because you, my subscribers, tend to be more short term oriented than you probably should be. Daytrading, of course, is the epitome of overtrading. Most people just are not equipped, emotionally, intellectually, or mechanically, to day trade and statistics tell us that most are not successful at it. If you are not making money at daytrading but keep on doing it anyway, you should examine your motives. If it's the action you crave, take up skydiving. It's safer and cheaper.

-- Spread Betting Risks: Excessive tape watching.

I get a kick out of people who insist that they're intermediate or long term investors, buy a stock, then anxiously ask whether they should bail the first time the stocks drops a point or two. Likely as not, the panic was induced by watching the tape, or hearing some talking head on CNBC. Watching the ticker can be fun. It can be mesmerizing. But it can also be dangerous. It leads to emotionalism and to hasty decisions. Try not to make trading decisions when the market is in session. Do your analysis and make your plan when the market is closed and the White Noise of the television and the ticker is absent, then calmly execute your plan the following day. You have your stop and your target. So go take a nap, or go to the movies, or mow the lawn. The only time you should be scrutinizing the tape is when you're looking for an immediate entry or exit point for a trade. Otherwise, do your blood pressure a favor and tune out.

-- Spread Betting Risks: Being undercapitalized.

If you have less than $50,000 to invest, you'd probably be better off in a mutual fund rather than trading individual stocks. To get proper diversification with a fully invested exposure you need at least 10 stocks. You do the math.

-- Spread Betting Risks: Letting the tax tail wag the stock dog.

Don't let tax considerations dictate your decision on whether to sell a stock. Pay capital gains tax willingly, even joyfully. The only way to avoid paying taxes on a stock trade is to not make any money on the trade.

-- Spread Betting Risks: Relying on gurus.

I'm spitting in my own rice bowl here, but you should not be letting some self-appointed market "gooroo" dictate or dominate your trading decisions. The most you should expect, or accept, from folks like me are a few trading ideas, a little technical analysis tutoring, and a bit of guidance in maintaining a solid trading discipline. You should not think of a market letter (ANY market letter) as a substitute for a personally managed portfolio. No one knows or cares about your personal circumstances like you do; how much money you have to invest, your tolerance for pain, your goals, your most suitable and comfortable time frame, etc. And you should be doing everything in your power to make Nick's Picks unnecessary and irrelevant to your trading, to learn enough not to need the likes of me anymore. Read some books. Take some courses. Buy some decent charting software and arrange for a data feed.

-- Spread Betting Risks: Thinking this market stuff is easy.

Don't confuse genius with a bull market. It's not that hard make money in a roaring bull market. Keeping your gains when the bear comes prowling is the hard part. Don't get cocky, but don't grovel either. You're not as smart as you think you are when everything is going great. But you're not as dumb as you think you are when everything is going to hell either. The market whips all our butts now and then. The whipping usually comes just when we think we've got it all figured out.

-- Spread Betting Risks: Thinking rather than looking.

One thing you should be thankful for is that you don't HAVE to come up with a reason for WHY the market is doing what it's doing. The talking heads on CNBC do because that's their job. I do too, because I know you expect it of me. But you don't. Just follow your chart work and let someone else do the pontificating. After all, who REALLY knows why stock ABC goes up 5 points on Monday while stock XYZ, in the same business, goes down 5 points? That's the great thing about technical analysis. You don't have to know. The price action is THE TRUTH. It's all you really need to know. Price doesn't lie. Price doesn't alibi. Price never complains and never explains. It is what it is. When XYZ goes up $5 on heavy volume, let Joe Hairdo on CNBC jabber on about what it all means. We KNOW what it means. It means XYZ went up $5 on heavy volume.

Pant...pant...pant.

These are just some of the mistakes traders make. There are lots more, but this has to end somewhere. These have been mostly generic in nature, applicable to fundamental investors as well as technical traders. One of these days I'll do another diatribe along these same lines, but confine it strictly to TA do's and don'ts. Until then, trade smart.

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