Trading Less Can Mean Profiting More

I've noticed a curious relationship between my profitability and the number of positions taken during a particular session. Invariably, I'll make more money when trading less often and incur my biggest drawdowns when flipping the most stocks.

All market players go through periods of poor performance driven by overtrading. The reason is simple -- we feel an overpowering urge to be in the action, regardless of whether there are good setups to exploit. For me, overtrading tends to run in regular cycles.

I'll be on a roll, taking in good profits each day. Without warning, I go on autopilot and start to trade without finishing up my homework. This mindless behavior continues until a wake-up call comes in the form of a big down day.

It's normal to increase position size and frequency when things are going well. But it's vital that we watch opportunity costs closely when taking on more exposure. We assume larger positions will yield bigger profits, while the opposite is often true.

Markets cycle in and out of good trading opportunities all the time. It starts when the crowd gets agitated and bids stocks substantially higher or lower. Those are the wild times in which traders can make a lot of money.

But that level of intensity is a fleeting emotion on Wall Street. Markets tend to run in place the vast majority of the time, forcing traders to be selective about their positions. These dull periods can be particularly destructive when you overtrade.

Smaller losses incur more damage to trading accounts over time than deep stab wounds. In other words, you'll lose more money from small losses triggered by mediocre positions than being on the wrong side of poor earnings, short squeezes or unfavorable FDA decisions. I call this unpleasant experience "death by a thousand paper cuts."

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Alan Farley is a professional trader and author of The Master Swing Trader. Farley also runs a Web site called HardRightEdge.com, an online resource for trading education, technical analysis and short-term investment strategies. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback; click here to send him an email. Also, click here to sign up for Farley's premium subscription product The Daily Swing Trade brought to you exclusively by TheStreet.com.

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