Ten Stock Market Traps

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  1. Getting caught up in the bargain-hunting game. The stock market is not a supermarket. If a stock is declining, despite what logically appears to be a very cheap price, there is a good reason for it. Professional traders may be aware of bad news about the company that is not generally known. Better strategy: Buy stocks that are acting better than the market as a whole. (Stocks that outperform the averages during rallies and declines.)
  2. Being too quick to take profits while holding on to losers. Most investors buy a stock at, say 20, and they sell it at 23 or 24. They may do this successfully a few times. The trap: Eventually they buy a loser and watch it plummet, wiping out all their previous profits. Preferable: Let your winners run. Cut your losses.
  3. Averaging down. Most investors think that if a stock is a good buy at 20, it must be a even better buy at 15. Common sense rule: If a stock acts poorly after you buy it, you probably made a poor decision. Admit your error, and move on to another situation. Even the smartest professional investors make mistakes. It's how you handle these mistakes that makes winners out of losers.
  4. Buying stocks based on news headlines. Stocks go up in anticipation of favorable news. When the good news finally comes out, it may be too late to buy. The stock may be close to a top.
  5. Holding a stock without a stop-loss order. The stop-loss order give you selling discipline. And it enables you to cut losses and hold onto gains. Where to place a stop-loss order: Just below the last meaningful low in the stock.
  6. Buying a stock without a potential upside target in mind. Learn how to evaluate the risk/reward ratio of a stock. If you buy a stock at say, 20, and you see its downside support as 15 and its upside potential is 35, you have an attractive speculation. Rule: Always look for at least a three-to-one risk/reward ratio.
  7. Trying to be fully invested at all time. There are certain times when it's better to be out of the market altogether.
  8. Buying a stock without looking at its chart pattern. First determine from the chart whether the major trend of the market is up. Then look for the strongest group in the market. Last, pick the stock that shows the best relative strength of the group. Key: Look for a stock that isn't too far above its support level. That way if you are wrong on timing, the stock might still find support only a little below where you bought it.
  9. Trying to catch the exact low of a stock. It's nearly impossible to do consistently. Stocks frequently take a long time to bottom out. Thus, your capital may sit idly for some time before the stock breaks out of its base.
  10. Being afraid to sell short. Simply forget the specter of unlimited losses in a short sale with a limited gain. You can avoid the prospect of enormous losses by shorting with a buy/stop-loss order.

Excerpt from: Book of Inside Information based on Sten Weinstein, investment counselor and publisher.

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