Hidden Dangers That New Day Traders Face
Knowing just enough to be dangerous is a common trait among new day traders. On the surface, day trading looks like it should be easy. Jump in and out of trades as the price moves, make a little profit and then do the same thing tomorrow. The problem is that you can't know what you don't know, or in other words, new day traders are simply unaware of the dangers that can drain their trading account...until it is too late.
Let's remedy that. Here are some of the dangers you face as a new trader, which you probably haven't thought of, and if you have you likely haven't put safeguards in place to protect yourself against them.
Lack of Risk Management
The biggest danger new day traders face is not having risk management protocols in place, or having an incomplete risk management strategy. New traders are usually optimistic about their trading skill (why start trading if you aren't optimistic about its potential), which can lead them to overlook important risk management steps. Here are two steps to take to make sure you have at least a basic risk management strategy in place.
- Control your risk on each trade. This means placing a stop loss on every single trade you make. When starting out as a day trader, your risk on a single trade should never exceed 1 percent of your trading account balance. The risk is defined as the difference between your entry price and stop loss price, multiplied by your position size (how many shares, forex lots, or futures contracts you take on a trade).
- Controlling your risk on each trade is a good start, but if you don't know what you are doing, you can still lose a pile of money even if you only risk 1 percent per trade. If you take lots of trades each day and lose the majority of them, you may still find yourself down 10 percent or more in a day. For that reason, implement a daily stop loss limit. The daily stop-loss limits how much you can lose in a day. Typically this shouldn't be more than about 3 percent of your account. If you lose 3 percent or more in a day, you are done trading for the day. Once you are experienced with a profitable track record, your daily risk limit should be equivalent to your average profitable day. That way, a losing day can be easily recouped by a typical winning day.
Lack of, or an Improperly Tested Strategy
Eager to get trading and making money, many new day traders read about a strategy, like how it looks and so they jump in and start trying it out with real money. Others are a bit more cautious, and try demo trading the strategy first. If they make money with the strategy over a few trades, they start trading it with real money. Both of these approaches are likely to lead to disappointment in the future.
Successful day traders test out a strategy in all different types of market conditions and learn the strengths and weakness of a strategy before using it with real capital. They do this through demo trading--typically for at least three to six months (or more)--as well as looking through historical price charts and seeing how the strategy would have fared in various market conditions (which may not have been experienced in demo trading).
Before risking real money with a strategy, know when you should trade it and when you should stay away. Know how the strategy performs when the market is trending, ranging, whipsawing, moving in chart patterns, when it is volatile and when it is sedating (and in between volatile and sedate). If you don't know these things, you won't know how to implement your strategy effectively when those conditions materialize.
Your broker is the biggest trade you will make. You are depositing all your capital with them, and yet many traders don't bother to research their broker until there is a problem.
Common broker problems include scam brokers (typically located outside first-world countries, although scam brokers can pop up anywhere), which will make it very hard or impossible for you to withdraw your money (profits and even just the initial deposit) once you have sent it to them. Scam brokers typically don't last long and show up repeatably in forum complaints, so an online search should reveal any major problems with a broker.
A more subtle problem is slow quotes or your broker trading against you. Day traders need a direct access broker, where the broker's software sends the trader's order directly to the appropriate exchange.
In day trading, every split-second counts, so if you place an order, you want it to get to the exchange instantly. If it doesn't, another broker that offers this will likely be able to serve you better.
The software is also a concern. A broker may be great, but if their software isn't good it will hard to trade on and thus not ideal.
Research everything you can about a broker before sending your money to them. Trade a demo account with them for several months, and test out their customer service before sending them money. 5 Steps for Finding a Great Forex Broker provides some additional steps you can go through to screen through potential brokers.
Another reason for having a stop loss on every single trade (see Risk Management section above) is because technology is a risk on every trade to you take. If you don't have a stop loss on your trade, what happens if your computer crashes? Your internet goes down? Your power goes out? Your broker's servers crash (you get disconnected from your broker)? There is no way for you to get out of a losing trade (quickly) in these cases, which means that while you sit there, helpless, you could be losing way more than you bargained for on your current positions.
The easiest way to help nullify this risk is to have a stop loss order automatically placed on every single trade you take. Most trading software allows for this functionality, so use it.
As additional protection, have your brokers phone number programmed into a landline phone and a cell phone, so you can contact them quickly if needed. If your internet goes down, it may also be helpful to have a mobile version (if available) of your broker's trading platform on your smartphone; that way you can use your mobile data plan to access the internet and manage your trades on your mobile device (as a temporary solution; day trading on a cell phone or tablet isn't recommended under most circumstances).
Lack of Order Knowledge
As a day trader, your profits and losses come from the orders you place. No matter what the price is doing, you should know your order types for getting in and out, both at a set price (limit orders) and if you need in/out in a hurry (market orders). You also need a grasp of how to set stop loss orders and profit targets, both for going long and short. Placing orders should be automatic, like flicking on the correct turn-signal when you want to change lanes while driving.
If you don't know your orders types, your trading will be slow and clumsy, which will cost you money. Far worse is sending out the wrong order, especially in an already bad situation. The image you place the wrong order. The market hits that order and you start to lose money. You realize your mistake and are upset that made it. Since it wasn't the order you were expecting, you fumble to think of the right order to get out of the trade. You panic as you watch your loss mount, and instead of getting out of the trade, you accidentally hit the wrong order again, adding to your position! Now you have an even bigger position and an even bigger potential loss.
Mistakes happen, but compounding them with additional order-related mistakes is a recipe for disaster. Know your orders types.
Hidden Dangers in Day Trading — Yourself, Your Tendencies and Your Personality
As a new trader, another hidden danger is yourself. When starting out, day trading will be stressful, possibly infuriating, and will tax your mind in ways you didn't think it could. The markets are an endless sea of possibility; you can buy and sell at any time, and no one cares whether you win or lose (except you). This sort of freedom is dangerous and unnerving for most people, which is why most people who try day trading lose money.
When you start out, you don't know how you will react under various stresses. Will you abandon your trading plan? Will you choose not to implement your risk management? Will you overtrade, or become too afraid to trade? Will you blame the market, and not take personal responsibility? If you do, you're making a big mistake. Are you even able to stay focused for a couple hour stretch while you trade? Many people think they can, but constant distractions keep them from trading effectively.
As much as possible, go through all the steps above to help minimize damage if you react negatively to the trading situation that may arise. Also look critically at your personality. See where your shortfalls are, and work to build up these six critical trading traits.
Final Word on Knowing Just Enough to Be Dangerous
If you are starting out and have read a few books, watched some trading videos and are dabbling in demo trading, you know just enough to be dangerous. To help minimize the danger you are exposing your capital to, always utilize a per-trade and per-day risk management strategy. Test and practice your strategy in diverse market conditions before using it with real capital. Don't take your broker for granted, as sending them money is one of the biggest trades you ever make. Technology is great, but it has drawbacks, too. Have redundant systems in place in case you get disconnected from your broker, and always have stop-loss orders on any open trade. Know your order types so well that you don't need to think about them when stress levels are elevated. Finally, realize that the biggest danger to your capital is you (it is you who must implement all the things discussed). Work on developing solid trader traits, and implement strategies for reigning in any problematic tendencies you notice in yourself.