How To Avoid Common Mistakes In Trading Stocks

Stock market is full danger. It is not to be taken casually.
First one needs to understand is different types of orders : market order, limit order, stop order and stop-limit order. Market orders are most simple. Whenever one enters a market order to buy or sell a stock it is executed immediately and one gets to buy or sell the stock at the market price at that moment.

(The following paragraph is taken from another article of mine)
However, in the beginning when I first started trading it felt like market orders are orders such that when I buy a stock, it immediately goes down. Then what is a limit order? It is an order to buy or sell stocks where one can specify a price. This sounds well and good, but actually what happens is the following: one either puts an order to buy at a price so low that the order never gets filled, or if one puts a reasonable price, it gets filled but when one check one's account, the stock is trading at least five points below. More on the limit orders later. But let us undestand the third type of orders : stop order. What about stop orders? It is an order one is supposed to use to lock in profit. Sounds wonderful! Here is how it works. Let's say you bought a stock at $40 a share, and now it is trading at $50 a share. So you put a stop order to sell at $45. And you are happy that you will at least make $5 a share profit for this one. Well, one day the stock opens at $35, reacting to some bad news. Your order gets immediately filled. Later in the day, however, one institutional buyer, some hotshot fund manager of Janus super growth fund family, comes in, and the stock closes at $47, down only $3 for the day. So in stead of making $10/share profit, you are left with a humiliating loss of $5/share. So one can see putting a market order is uncertain, limit orders difficult to execute, and stop orders are completely beyond your control.


Importance of Stop Order

Even though all kinds of orders have drawbacks, one needs to undestand the importance of stop order at the very beginning. As described above, it is order to protect profit and also to cut losses. To understand the stop orders, let us look at where stock is on nice uptrend and you have bought at the point specified. It looks like you are climbing a mountain, right? Only difference is unlike mountain climbing, you are not having any control on the stock price now. Only thing you can do is wait and watch. If other traders buy this stock, the price will keep rising. If, on the other hand, others decide to sell the price will go down. Unlike in mountain climbing, you do not know what lies before you. Do you want to be in that situation? What is the solution? That support level is your stop price. Never ever enter a trade without a stop order. But this is the mistake most traders make in the beginning, including myself. If it feels like burden to you then think of why you wear seat-belt in a car or pay hefty premium to insure your home. In the first example do you regret if you did not have accident so the seat-belt did not prove to be useful. In the second case, are you unhappy your home was not destroyed by fire or flood so you could not use the insurance?

There is another aspect to protecting your capital. As you loose your capital, it becomes harder to recover from the loss. For example, you start with 1 lakh rupees. If you loose 10%, you are left with Rs 90,000. Now from this point, you have to gain 11% to get back to your original value. Similary, if you loose 25% (you now have Rs 75,000), you have to gain 33% to recover all your losses. If you loose 50%, you have to gain now 100% to recover all your losses. If you loose .... well let us not get that depressing. You got the idea.

Temptation of Limit Orders

In the beginning, everybody want to use limits order to buy and sell stock. This is because it allows one to buy at a lower price and sell at higher price. Some people are attracted by the daily fluctuation of a stock and think as if they can make money by trading by limit orders. One may get lucky a few times, but if anyone think this can done consistently to make money one is dreaming a fools dream. If you think you can stock price movement each day, you might as well think you can predict lottery numbers or outcome of any elections. Don't they all look familiar after the result are out? I would not dig deeper into the lottery case, but in the election scenerio, remember Bush-Al Gore, or Cong vs BJP last time, or Cong vs BJP in 2000? I can go on, but you get the idea.


Is it market top or bottom?

It is also very important to identify market tops and bottoms. Novice investors always get lured into market top and forced to sell at market bottoms. How is this possible? The end of see-saw is way up and there so many people cheering. Now is the time to go down. In wall st lingo (Dallal st for India) there are too many bulls. So there are not many people left to buy stocks and stock price rises if there are more buyers. Similarly, at the bottom there is nobody around (because everyone is scared to own stocks). It is time for the market to make a move up.
Some people may not agree with this explanation of market's movement. But see-saw nature of the stock market can not be emphasized enough. Market is always going from up days to down days, from bull market to bear market, from being overbought to oversold, from euphoria to doom and gloom, and most importantly, from insatiable greed to extreme fear.
I may have become little philosophical. Coming back to cold hard reality, it is very important to understand the market top and bottoms. Common investors, however, should not try to catch a market bottom. It is a very dangerous thing to do so. There is no way one can always catch a market bottom successfully. One should wait when the market stabilized enough to enter. However, one should always be wary of market tops to take profit or be careful enough not to get into it.


Silver Lining

If this all sounds very depressing to you, then consider these stories.


-- George Soros : Immigrant from Hungary. He is the world's most famous currency trader. He became a billionaire by shorting the

british pound. He is often blamed for crashing the bank of England!!


-- Warren Buffet : World's second richest man! Became wealthy by investing in Coca Colla, Gillette, Citibank, etc and holding them for more than 30 years! He bought shares of Coca Colla and Citibank when traders dumped those stocks for junk. He never bought a single share of technology company, not even Microsoft.


-- John Templeton : Arguably the greatest global stock picker of the century by Money Magazine (Jan. 1999) also made his fortune by picking stocks at very low price. Founder of Templeton family of mutual funds.


-- William O'Neal : Founding editor of Investor's business daily. Made millions from stock market before starting his newspaper. He also authored several best selling books on investing.


-- Jesse Livermore : A remarkable character in investing. He made and lost millions of dollars many time over. A very thinly disguised biography of this person named 'Reminiscences of a Stock Operator' is an all time best seller in the investment literature.


-- Nicolas Darvas : He made $2,000,000 from merely $10,000.00 in just eighteen months. How he did that is recorded in his best selling book 'How I Made 2,000,000 in the Stock Market'.


-- Bernard Baruch : From $5 a week wall st job, he rose to managing multi-million dollar portfolio. Later became a statesman and presidential advisor.

So are you ready to make your million from the stock market? Start trading, but on paper first. Also do not forget to do your homeworks.

Copyright © 2005 Gautam Dev. All rights reserved

I am a software engineer and occasional writer.

If you like this article please send me a feedback to gdind2003@gmail.com.

If you would like, you can also visit my home page, http://www.stock-article.com/.

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