One of the biggest mistakes that traders make is to keep adding to a losing position, desperately hoping for a reversal. As traders increase their exposure while price travels in the wrong direction, their losses mount to a point where they are forced to close out their positions at a major loss or wait numbly for the inevitable margin call to automatically do it for them. Typically in these scenarios, the initial reasoning for the trade has disappeared, and a smart trader would have closed out the position and moved on. (For related reading, see The Art Of Selling A Losing Position.)
However, some traders find themselves adding into the position long after the reason for the trade has changed, hoping that by magic or chance things will eventually turn their way.
We liken this to driving in a car late at night and not being sure whether you are on the right road. When this happens, you are faced with two choices:
- To keep on going down the road blindly and hope that you will find your destination before ending up in another state
- To turn the car around and go back the way you came, until you reach a point from where you can actually find the way home.
This is the difference between stubbornly proceeding in the wrong direction and cutting your losses short before it is too late. Admittedly, you might eventually find your way home by stumbling along back roads - much like a trader could salvage a bad position by catching an unexpected turnaround. However, before that time comes, the driver could very well have run out of gas, much like the trader can run out of capital.
Do Not Make a Bad Position Worse
Adding to a losing position that has gone beyond the point of your original risk is the wrong way to trade.There are, however, times when adding to a losing position is the right way to trade. This type of strategy is known as scaling in. (To learn more about scaling in, see Tales From The Trenches: Trading Divergences In FX.)
Plan Your Entry and Exit and Stick To It
The difference between adding to a loser and scaling in is your initial intent before you place the trade.
If your intention is to ultimately buy a total of one regular 100,000 lot and you choose to establish a position in clips of 10,000 lots to get a better average price (instead of the full amount at the same time) this is called scaling in. This is a popular strategy for traders who are buying into a retracement of a broader trend and are not sure how deep the retracement will be; therefore, the trader will scale down into the position in order to get a better average price. The key is that the reasoning for this approach is established before the trade is placed and so is the "ultimate stop" on the entire position. In this case, intent is the main difference between adding to a loser and scaling in.
What Is Mathematically Optimal Is Psychologically Impossible