Three Common Trading Pitfalls to Avoid

It's a fantasy born from the trading-floor imagery that, since organized markets began, has been used to portray the investment world. The stock footage of type-A personalities screaming, yelling and waving their arms in a pit or at a trading post aren't traders but rather market makers whose profits are made not by predicting the direction of a market, but simply by facilitating trades across the spread. Nowadays, computerized black-box algorithms have virtually eliminated that element of the game.

Real profits aren't made by trading in and out of a stock, but by having the foresight to take a position ahead of the herd and riding it the duration of a significant move in valuation. To that end, there's nothing particularly beneficial about gaming a stock for a 5% pop, since you need to have a big chunk of capital at risk for such a blip to have any appreciable effect on the bottom line. The big money is made on the big moves.

Think of trading as being akin to the surgeon making incision with a scalpel: It's necessary to complete the task, but should be done as prudently and efficiently as possible.

In my book, stocks aren't safe or risky, but strong or weak. And although there's no foolproof approach, the better odds always rest in focusing on the comparatively better performers.

I don't judge a stock by its sector, size or reputation, only by its price action and performance in the marketplace. And although it's human nature to gravitate to fallen angels in hopes of snagging a value, it's precisely those situations that have a tendency to go from bad to worse.

So out of 10 different investment ideas, it's quite possible that only two or three of them will actually perform as expected. But if you're able to limit the worst losses to, say, 15% while letting the winners grow significantly larger, then you'll make money even when the majority of your picks don't work out. A scorecard usually ends up with a handful of losses, a handful of scratches and a small cadre of names that do exceptionally well.

So yes, I'll have plenty of picks like Gap (GPS) that fall or go nowhere fast. What saves me is the discipline that controls the losses and allows the occasional winner to more than make up the difference.

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Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC. At the time of writing, Hoenig's fund held positions in some of the securities mentioned.