The No1 lesson you must learn as a trader

published 13 January 2012

How often do you reckon a successful trader gets it right? 60%, 70%, 80% of the time? Not a chance!

Most traders don't get anything near that sort of hit rate. At least not the traders I talk to. Many of the best traders have a hit rate of well under 50%. Sometimes as low as 20%! But they still make money overall.

This all comes down to what's probably the most important lesson you can learn as a trader. That is: maximise your winners and minimise your losers.

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Even if you don't consider yourself a trader, keep reading. This is for long-term investors, too.

In my experience, many trading concepts can be incredibly useful for your long-term investment approach. Especially this one...

Imagine you're learning to ski. You're descending nervously down the slope when things start to go wrong. You're building up speed and you're going too fast to put in a turn. That's when most sensible novices sit down a self-induced fall you might call it. If not, you end up gathering pace and setting yourself up for an almighty wipe-out.

That's kind of what I'm talking about here. When your losses start to gather pace, you need to get out of the trade. A calculated crash and minimised loss means you can get up and have another go.

In terms of trading, what we're talking about is setting relatively tight stop-losses. A stop-loss is basically an instruction with your stockbroker to quit your trade if it hits a predetermined level. It quite literally stops' your loss from escalating.

My colleague John C Burford often refers to his 3% rule. Never put more than 3% of your cash at risk with any one trade. So if you have £10,000 in your account, don't risk losing more than £300 on any one trade. Work out where that loss is and place your stop there.

The only thing I'd add is that your stop should also relate to the stock's volatility and trading range. I've written about that before.

Now clearly such a tight wealth preservation strategy could trigger a lot of stop-losses. As a successful trader, you're going to have to accept not just the occasional loss, but a lot of them.

That's why most investors don't make for good traders. Most can't accept that in this game you never progress further than the novice' level. The most common shortcoming for a trader is that he thinks he's an expert. He's not going to sit down before he falls down and he sets himself up for a serious wipe-out.

But of course you're never going to get rich by just cashing in losses...

Why it's important to let your winners run

To make up for your losing trades, you're going to have to make sure you squeeze some serious profits out of your winners. This is tougher than it sounds.

With a stock moving up, emotions run high. There's a very real danger of getting trigger happy... glued to your monitor, with your hand on the mouse, it's all too easy to snatch a quick profit. "You'll never go broke cashing in a profit" is dangerous advice.

What you want to do is make the most of the momentum. Ride your winning trades until you're confident the trend has reached the end. A trailing stop-loss could be great way of doing that. You keep moving your stop-loss up as the price goes up, selling once the stock drops a certain amount below its high.

The point is, minimise your losses and let your winners run. Depending on your timeframe and the volatility, you may aim to make something like 10% on your winners.

Let's say your normal trade size is £1k. That means you're looking for something like £100 on a successful trade.

That means that even if you lose 3% on three trades, you'll still come out ahead (having only lost 3 x £30 = £90). With a success rate of just one in four, you're in profit.

I've deliberately excluded trading costs because with today's trading platforms (Spread Betting and Contracts For Difference (CFDs) there's no need to pay traditional commissions. Of course, you'll still have to pay the spread (the difference between buy and sell price), so you should never try to trade anything but the most liquid stocks where the spread is minimal.

But you get the idea. If you have the discipline to keep your losses small and allow your wins to ride you stand a better chance of coming out on top.

How to translate the strategy for long-term investment

I'm convinced that most trading strategies work just as well with long-term investment. The only thing that changes is timescale.

I mean, if I showed you a chart of the FTSE without a timescale, you'd find it difficult to know if you were looking at a five-year chart, or a single day. And the point is, the chart plots more or less the same emotions whether you're talking about the long-term investor (overfive years) or a day-trader.

Many investors use exactly the same technical analysis as traders do. They're using the same emotional signals to give them their entry and exit points.

That's why I think that even long-term investors should have some trading experience and understand how to use basic technical (charting) analysis.

I can't think of a better way to learn about charts than by following John CBurford's free tutorials. He's a great teacher and sends out an email three times a week that I think could really help improve your trading and investing performance.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

Important Information

Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.

Spread betting is not suitable for everyone - ensure you fully understand the risks involved and never risk more than you can afford to lose. Spread betting carries a high level of risk to your capital. Prices can move rapidly against you and resulting losses may be more than your original stake or deposit. Margin amounts vary between spread betting companies and the type of markets spread bet.

Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.

Managing Editor: Frank Hemsley. The Right Side is issued by Fleet Street Publications Ltd.

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Bengt graduated from Reading University in 1994 and followed up with a master's degree in business economics.

He started stock market investing at the age of 13, and this eventually led to a job in the City of London in 1995. He started on a bond desk at Cantor Fitzgerald and ended up running a desk at stockbroker's Cazenove.

Bengt left the City in 2000 to start up his own import and beauty products business which he still runs today.