As a trader, we always look for confirmation before entering a new position. The same is true when we add to an existing position.
Regardless of your trading system, you use whatever the signal is to confirm that there is in fact a valid, tradable signal.
When it comes to adding to an existing position, we want to see a continuation of the trend in which we initially took the position, as well as another valid entry signal. Unfortunately, it’s the first component that causes traders a lot of grief. See, instead of adding to a position when the market moves in your favour, many traders tend to think that if they add to a position that goes against them they’ll make back the money they’ve already lost when the market reverses.
This is known as doubling down or averaging down, and let me tell you, it’s a guaranteed one way ticket to Centrelink, my friends.
What Exactly is Averaging Down?
For some reason, averaging down seems to be quite a popular strategy with trading, though I can’t for the life of me justify why. Essentially, averaging down is adding to a losing position to attempt to create a ‘better’ average entry price.
The problem with this is that the Forex market is, in no subtle form, telling you that you’re wrong about your trade and when you average down you’re basically saying, yep, I’m wrong… why don’t I waste even more money by being even more wrong. The most basic principal in trading is to cut your losses short and to let your winners run, so why do people still add to losing positions?
Don’t EVER Add to a Losing Trade
As I mentioned, the most basic trading principal is to cut your losses short and let your winners run. A losing position is a clear sign that your trade idea may not have been a good one, which should mean to cut your trade, take a loss and move on.
Why Mindset Matters
I’m sure at some point during your trading career thus far, you’ve noticed that one losing trade can tend to bring a few more losing forex trades. The reason that this occurs is because after suffering a loss, our minds tend to let negativity creep in. We start to hesitate, even allow fear to influence our judgement with subsequent trade setups. The easy way to combat this, as we’ve discussed previously in our ‘vanquishing trading villains’ post, is to just take a brief break from the screens when you find yourself on a bit of a losing streak.
The thing about adding to an already negative trade is that it’s no different to opening a new trade following a series of losses, with the exception that your already-open positions are at risk of even greater drawdowns. I’m sure you don’t need me to explain why this is can be catastrophic to your capital.
Is There a Right Way To Add to an Existing Position?
So, after going through why it’s an absolute MUST NOT to add to losing positions, there is a way to capitalise by adding to an open position. This is called pyramiding, or, adding to a profitable position. There are a few ways to go about this, but for me, it means that price is setting up with another pattern that indicated a new setup according to your trading plan. This could be the breakout of a support or resistance level, chart patterns, etc. When pyramiding you’re waiting for the market to confirm that your trade idea was in fact a good one. The market is giving you a reason to add to your open trade positions and you’re not increasing risk, unlike when you average down.
Wrapping It Up
It can’t be said more simply than ‘never add to a losing position’. This is one of the easiest mistakes to fix, yet one of the most damaging mistake a trader can make.
Yes, every now and then you might get lucky and profit by averaging down, but that success has a very short shelf-life. Instead, think of how you can capitalise on compounding and pyramiding your winning trades.
Source: Vantage FX Blog