Account blow ups can happen to any trader of any experience level. Not going to sugarcoat it: It is one of the most demoralizing experiences you can have. When I was a new trader in the 2000s, I blew up 3 times!
Consistently profiting from the markets is one of the hardest endeavors you will ever undertake. Account blow ups can occur on your journey toward profitability. However, if you know what causes account blow-ups, you can significantly decrease the probability of it happening to you, and increase the probability of you becoming a consistently profitable trader. Here are 5 common causes of account blow ups, and how you can make sure it won’t happen to you:
1. Over Leveraged
Leverage can be your best friend or your worst enemy in trading. For most new traders, it's their worst enemy. Leverage is simply borrowing money from your broker to buy or short-sell more stock. When used correctly, it can increase the size of your winning trades.
When used incorrectly, it can significantly increase the size of your losing trades. And most traders use it incorrectly. They end up blowing up, and worse, go in debt to their broker. With leverage, you can lose even more than what’s in your account value. Look at this video from earlier this year posted by a hedge fund manager after his fund blew up from being over-leveraged! It's not pretty:
It can happen to anyone who is careless, no matter how many years of trading experience you have or how much money you’ve made. Never risk more than 1% of your trading capital on 1 trade when you are new.
Stubbornness is one of the worst traits for a trader. Attachment to your opinions is one of the most common causes of account blow ups. The funny thing is that it's most often the smartest people who have done the most research on a company who fall victim to this. They refuse to believe that the market’s opinion is correct and don’t liquidate their position before the loss consumes their trading account.
Remember, as a trader, your goal is to make money, not to be right on every trade. Remember: “markets can stay irrational longer than you can stay solvent”. Tesla is a great example of this. Yes, it is a company with questionable fundamentals. But it has been in a strong uptrend ever since it IPOed (until the last couple months). Many funds blew up from Tesla because they were too stubborn to admit their thesis was incorrect.
3.No Stop Loss Strategy
“I just froze”. “I thought it would come back”. “It’s not a loss until you sell”. Most new traders make the mistake of assuming that every trade they put on will be a winner. They fail to prepare for the scenario of their trade becoming a loser. As a result, they don’t keep their losing trades small, and eventually, lose all of their money. Stop losses are not optional. No trading strategy has a 100% win rate. You need to have an exit strategy in the event a trade goes against you. For some of my favorite stop loss strategies, check out this article here.
I’ve seen thousands of traders give back weeks and months worth of gains after just a few hours of revenge trading. It is natural to make back the money you just lost. But you cannot force trades on subpar setups. Traders are at their most vulnerable right after a losing trade, as they often get emotional. We misperceive opportunities in the market because we want to make back the money we just lost so badly. To combat revenge trading, I recommend using a daily max loss, meaning that after you lose a certain amount of money during the trading day, you stop trading for the day. For more tips on how to combat revenge trading, check out this article here.