Price action in the first half of January is one of many reasons why a trader (or investor!) should never have all of their money in a single asset or strategy.
The biggest risk to new traders in these situations is that they try to force a trade or all of a sudden decide they’re breakout traders. Both errors generally end in losses:
- Forced trades: maybe an ETF pulled back just a little. In normal times a trader wouldn’t think to enter because there’s not enough of an edge. Alternatively the trader might start looking outside their previously defined investment universe. The worst-case scenario is that the trader finds a stock or ETF that has significantly pulled back and he takes the trade. The question that should be asked is if everything is going gangbusters, why is this stock or ETF not joining in? Most likely answer: it’s not going to mean-revert and the trader will suffer a loss.
- Breakout traders typically experience win/loss ratios of 1:5 or worse. The only way breakout trading works is if you have a bunch of small trades going at the same time and the big winners make up for all of the small losers. A new trader will often make the mistake of using the same position size for a breakout trade as they do for a mean reversion trade. Most typical result: the position doesn’t break out and the trade is closed out for a loss.
So what’s the solution?
This advice might seem strange considering it’s on a website devoted to trading, but my best advice for new traders: wait to allocate a portion of your capital to trading until you have a healthy sized Buy & Rebalance portfolio already established. Trading should just be another part of your portfolio, not the whole kit and caboodle.
And if you already have a diversified portfolio established, when stocks go straight up like they have recently, it’s a great time to rebalance back to your targeted allocation.