Traders and the Death by a Thousand Cuts

People think huge, sudden losses are the most common kind for daytraders. It isn't so.
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There is a misconception about how daytraders lose money. Many people think traders typically lose it all suddenly, gambling in high-risk situations. While that does happen, more often I've seen people lose in slower, frustrating cycles of small gains and small losses that don't add up to a profit.

Why is that? It's usually a lack of focus. Traders can have a sound strategy and understanding of the market but still lose because emotions sabotage their trading.

He Who Hesitates

Let me give you an example. I know a trader who is struggling -- let's call him Joe. He tends to make emotional decisions and second-guesses himself a lot. Last Friday I watched him make a trade on the

Nasdaq 100 Trust

(QQQ) - Get Report

that really exemplified this problem.

What to Do?
Friday's QQQ action baffled one trader

After a negative open, buyers moved in early, and we saw an initial pop to $35.64. That early top was higher than the previous day's intraday high, so we suspected a potential market change.

Around 9:45 a.m., though, the market started topping off. Key stocks such as

Adobe Systems

(ADBE) - Get Report

,

OSI Pharmaceuticals

(OSIP)

and

Nvidia

(NVDA) - Get Report

began pulling back, so some of the more aggressive traders moved into shorts at that point. From there, the QQQ moved down from $34.64 to $34.15, and those who were short started exiting and posting their gains in the room.

This created the first problem: regret and envy. When struggling traders see others post gains while they were too timid to enter, they start feeling foolish and left out. Filled with regret and frustration, they look around more aggressively for that next chance. The problem, though, is that the next chance is not always as predictable as the one that just passed. Not wanting to be left out again, they chase after those unpredictable trades anyway. This was the case with Joe.

Around 11 a.m., the QQQ started retesting the early high. We were watching the R1 (which is the resistance level 1) near $35.57, as potential resistance, and particularly $35.61, four ticks above that level. But because we'd already seen higher highs that morning, the possibility of a market turnaround and more buying was still there. So it was do or die at that barrier. We had the option of shorting that retest, or waiting and going long on a breakout. By then, though, the general pace of trading in the market had slowed, and that decreases predictability.

Lost

The retest failed, and the QQQ drifted very slowly down to $35.41. It came back up and slowly retested the R1 again at 11:30 a.m. Again it failed and slowly started drifting back down. Joe sat there watching it. He was torn: Should he short? Would resistance hold? Was this his chance for revenge?

Finally, at about noon, he decided to enter a short at $35.50. He felt uncertain about it, though, and asked the chat room for advice. He also mentioned that he'd been struggling lately. So on top of feeling insecure about his trade, he was under pressure.

His reasoning was he felt that $35.61, four ticks above the R1, could hold as resistance, and that we would see some afternoon selling. So his stop was placed at that barrier. The more experienced traders, who are always generous with advice, told him to be patient because the market was slow, and to watch his stop.

Trading is a lot like walking across a river on a log. If you stay focused on your goal, you can usually get across just fine. Balancing is not that hard. When you start looking down at the rocks, though, and worrying about what could happen to you, that's when you fall. It's all in your head. And that is what happened to Joe on Friday.

After his entry at $35.50, the QQQ drifted down to $35.41 again. It then drifted back up again. As it neared his entry price, he started looking around at the rocks below. He started seeing stocks climbing. He lost sight of his plan and suddenly doubted himself. His whole trade was based on the idea of $35.61 resistance. But instead of focusing on that plan, as soon as he got a little scared, he exited again at $35.50.

This is why many traders lose. It isn't always the big losses that take them out of the game. It is often a series of frustrating small losses and a cycle of spinning wheels and getting nowhere. It is the emotional turmoil that causes erratic, unfocused trading. He didn't take a loss in this case; he got out flat. But he did pay commission fees for nothing. And he also practiced some bad habits.

After he exited, the QQQ drifted up to $35.60, but held below the $35.61 resistance level, which was his original stop and the whole reasoning for his trade to begin with. It then proceeded to sell down to $34.91. If he had just been patient and held to his plan, he could have closed the day with a nice gain. His reasoning and stop were right on. His emotions sabotaged the trade.

As originally published, this column contained an error. Please see

Corrections and Clarifications.

Ken Wolff is founder of MTrader.com, the first educational daytrading site on the Net, and co-founder of Investingonmomentum.com, a Web site devoted to short-term potential for retirement accounts. TheStreet.com has no affiliation with InvestingOnMomentum.com, and no endorsement of InvestingOnMomentum.com or momentum trading is intended. At the time of publication, Wolff had no positions in any of the securities mentioned in this column, but positions may change at any time. While Wolff cannot provide investment advice or recommendations here, he invites you to send your feedback to

ken.wolff@thestreet.com.