Add to a Losing Position or Not?
Add to a Losing Position or Not?
This week I'm going to discuss a very hot topic in the trading community - when is it okay to add to a losing position? The easy answer would be to say never ever do this. The more complicated answer is to say, "If my original reason for being in the trade is still valid and my first entry wasn't great, a second entry is allowable." However, a couple of extra rules are necessary if you choose to allow this trading strategy into your trading plan.
The first rule I'll share is this: On your first entry, you must get into the trade with a small position size, knowing there is a possibility you will add to this trade. You must have planned this with your risk management rules on position sizing, otherwise you may not add to this position.
For example: Trader Joe has a $10,000 trading account and his risk management rules state that he will risk 2% per day and 1% per trade. This means he may risk up to $100 per trade, or 100 pips on a 1 mini lot position. With the trade he is looking to enter, he knows that he missed the better entry at the 50% Fibonacci retracement level. According to his trend following rules, he may also enter at or near the 38%. In this case, he sold at 1.3155. His stop loss would be at 1.3200 (45 pips) and his profit target 1.3020 (135 pips), for a 1:3 risk:reward ratio. If Trader Joe would have entered with 2 mini lots, he may not add to this position because he would be risking his entire 1% or $100 on that position. But because he knew he missed the better entry, he went in with Ω the possible position size knowing that adding to this trade is a possibility.
The second rule is this: Your original reason for being in the trade must still be valid. After a few hours go by, Trader Joe realizes the EURUSD isn't falling as fast as he would like, but the downtrend is still valid and we haven't broken the 38% Fib retracement level. He decides to add 1 mini lot near the 38% Fib level at 1.3165. The original stop loss and profit targets remain the same. He is now risking a total of 80 pips (45 + 35) which is still less than the 1% of his account allowed in his trading plan.
A few more hours go by and Trader Joe's profit target is finally hit.
I cannot stress enough the importance of following these two simple rules when choosing to use this strategy. Many times we are tempted to enter a trade because it is moving right now and we don't want to miss the opportunity. Please take the time to evaluate the overall trade! You must be very honest with yourself in this evaluation and be strict in your risk management discipline. In my experience, this technique works better in a trend following strategy than a trend reversal strategy. The major differences between these two strategies will be discussed in a later article.
Figure 4 shows what might happen to a novice trader who does not follow the rules outlined above. After a long entry at a demand level of 1.01493 on the AUDUSD, the novice trader continues to add to this position at subsequently lower demand levels. Without having risk management rules in place, this trader will end up with a huge position in a trade going the wrong direction. Do not blindly keep adding to a losing position!
There are thousands if not tens of thousands of former traders who decided to add to losing positions with the hope of the trade coming back. This is a very fast way of ending your trading career.
In every Online Trading Academy class I teach, there are students who admit to adding to losing positions with no rules on how to do it. As I asked in the last Lesson from the Pros, how many trades does it take to blow up your account? One! Is it this one? If you follow these rules, this trade will not be the one to blow up your account.
View Rick Wright's post archive >