Trading stocks and options can play tricks on your mind. Control as much as you can to reduce the risks you can't control. Avoid these four trading mistakes.
Everyone makes mistakes—that’s no secret. For trading rookies, some are more the “oops-I-didn’t-know-that” type. That’s okay; you live and learn.
But even when you’re experienced, trading mistakes still happen—and they can be more insidious and can involve bigger numbers. Trading can play tricks on the most experienced trading mind. The key is to control as much as you can in order to reduce the risks you can’t control. And that means we need to look at trader psychology. Can you prevent bad decisions that’re driven by emotions or plain wrongheadedness?
One way to ditch the mind games is to trust technology and other resources that are designed to counter your emotions and internal biases. Here are four common mistakes traders make and what to do about them using the tools you already have.
An entry choke happens when the signals or conditions to make a trade are there, but you don’t act—or you wait too long.
The lesson: Some traders remember their big trades—and trading opportunities—in the same way a lot of baseball fans know every batting statistic for the last 40 years.
Here’s a scenario most traders can relate to. It might even describe something you’ve experienced. You say, “I’ll load up the boat with XYZ if it gets down below $100 per share.” But then it moves from $120 to $95 so quickly you don’t pull the trigger. You have visions of catching falling knives, stepping in front of a train, or whatever metaphor you prefer.
And then the next day it’s back above $100, but you still can’t bring yourself to buy it, because you choked at $95.
The wisdom: Forget trying to figure out why you get scared. Traders choke because there’s money at stake—real money. But how do you tame those demons? Gut-check and stress-test your strategy on the thinkorswim® platform (all the tools are there under the Analyze tab) before you send the order and well before your signal is met. See what the loss might be on an options trade under various scenarios: different stock prices, implied volatility levels, or days to expiration. If you can’t handle the potential loss on that trade, consider a lower-risk strategy.
Your directional bias proves to be correct, but your position loses money.
The lesson: XYZ has just hit your buy signal, and you see an impending rally. You want to risk $200 on this trade, so you buy a one-week 0.20-delta call option that’s trading for $2 (remember the multiplier for a standard U.S. equity options contract is 100, as each contract controls 100 shares). Three days later, XYZ pops $5 per share. Time to scoop up your winnings, right?
Not so fast. Remember, this was a one-week option. So not only did the delta likely go lower, but you’ve also lost three days of time decay (theta). That might have wiped out your theoretical profit. You might even be down on the trade.
The wisdom: You probably won’t learn about how time decay, volatility, and stock or index price movement all happen simultaneously in your MBA program. But you should take advantage of the educational resources that TD Ameritrade offers. Immersive curriculum. Live webcasts. An archive of hundreds of articles and videos.
A position looks like it can’t lose, and you take it way too big.
The lesson: Once upon a time there was a trader—not naming names here—who saw what appeared to be a slam-dunk layup: a synthetic options position that looked to be out of line with the stock price. So he placed a large order—way above his standard unit size—expecting to close it out for a nice win as soon as the market was brought in line.
When he showed his savvy setup to a fellow trader, he was asked, “Uh ... did you check for dividends?”
It turned out the stock was going ex-dividend the next day. When the dividend payment date came up, as the holder of long stock as of the ex-date, he was on the hook for the dividend, which more than wiped out his profit on the trade.
The wisdom: Each TD Ameritrade platform has a dividend calendar, so it’s easy to check for these things. Plus, TD Ameritrade account service and support is available 24/7 at 800-669-3900. It’s staffed with associates who have seen just about every kind of trade and strategy ever done. They can help you spot the potential risks and rewards of your trade ideas. It’s not that your idea is necessarily bad, but it doesn’t hurt to have an experienced pro take a look at it.
In this day and age, with arbitrageurs running algorithms day in and day out, if you’re a retail trader and something looks too good to be true, it probably is. You might want to think twice, or at least play it small.
You start your market analysis with the answer already in your head and shut out results to the contrary.
The lesson: If you’ve ever done backtesting on a strategy (which you can do via thinkOnDemand, by the way), you know that correlation is not causation. And yet, many traders fall victim to the so-called “spurious correlation” fallacy. And that’s just one internal bias—there are a dozen or more, from overconfidence, to recency bias, and even the “sunk-cost” fallacy, which can lead to stubbornness or doubling down on a loser. Biases tend to lead traders to downplay or outright ignore the risks of a certain trade and thus throw off the risk/reward ratio.
The wisdom: Whatever strategies you use, numbers rarely lie. In addition to thinkOnDemand, you can test various entry and exit signals using the Strategies feature (found in the Edit Studies function of thinkorswim under the Charts tab). In the upper right of any chart, select Studies > Edit studies … > Strategies > Add Selected > Apply. Then right-click on your strategy and select Show Report. This allows you to see a report of the potential profit and loss for that strategy.
It’s been said that knowledge comes by learning from your mistakes. But true wisdom is achieved when you can learn from the mistakes of others.
If you’re a trader, you’ve made mistakes, and hopefully you’ve learned from them. But you’re not the first to have made each of your mistakes, nor will you be the last. And it’s pretty much guaranteed that countless others have made those same errors. Can you learn from them?