If there is one thing I’ve learned in all my years in the financial markets, it is never add to a losing position.
That means never “average down” a losing long position or “average up” a losing short position. This is even more important when using leverage. There is a very well-known saying, “your first loss is your best loss.” What this means is you are best served taking a small loss before it becomes a larger loss, or even worse, a loss that eats up a majority of your trading capital. In order to avoid this major trading mistake, we must first understand why traders add to losers, why traders should not do this, and what they can do to stop it from happening.
Why Traders Add To Losing Positions
Traders stay in losing positions for only two reasons. Either they don’t want to be wrong about the market or they don’t want to lose money on the trade. Sometimes it is a combination of both. Regardless of which one it is, it causes traders to stay in positions that are going against them.
As traders are losing money, they figure that if they add to the losing position, they can bring the average cost of the position down. For example, let’s say a trader wants to be short Hindalco and he sells 1 contact of Hindalco Futures at 176. Hindalco Futures are now trading at 182, and the trader is down Rs. 6 or (21,000). The trader then decides to sell short an additional 2nd contact at 182. The average short position is 179 (the average of 176 and 182).
The trader now only needs Hindalco Future to go Rs. 3 in his favor to get to breakeven at 179, instead of 176. However, every tick of Hindalco Future going against the trader past 182 is going to count twice as much, eating up available capital a double the rate. To make matters worse, markets that are trending in one direction, tend to continue to trend in that direction for at least some time before reversing the trend.
Why Traders Should Not Add To a Losing Position
When a trader is in a losing position, the market is telling him he is wrong. The market is the total sum of psychological, technical and fundamental knowledge. The market is the total sum of all investor knowledge and market opinions. It includes institutional money, sovereign wealth funds, hedge fund managers, trend following funds, commercial hedging interest, and every other participant, large and small.
If a trader continues to hold onto a losing position after the market says he is wrong, the trader is basically saying he is right, and the collective sum or the rest of the market is wrong. In other words, the global consensus is telling the trader the world is round while the trader insists the world is flat. This will almost always lead to larger losses. Bullish markets tend to trade higher, and bearish markets tend to trade lower. It takes something significantly fundamental or technical to occur in that market to change the trend.
Not only is the trader wrong shorting Hindalco at 176, he is twice as wrong shorting the market again at 182. The losses are now piling up exponentially if he continues to add on to a losing position. Plus, he has now doubled his leverage on a bad trade. Meanwhile, if the trader had just had a Rs. 8 stop on Hindalco short position, he would have taken his loss and been done with the trade. He would have been able to admit he was wrong and move onto the next opportunity, instead of creating larger losses and letting other opportunities go by while he was in a losing trade.
Wait Just A Second, I Have “Averaged Down” and Made Money!
If you have averaged down losing positions before, chances are it may have worked in your favor. The problem is, the one time it does not work in your favor you will blow out your account. Every time you “average down” and succeed you are cheating trading death. It is almost like a game of Russian roulette. It only ends once, and when it does, it’s over.
Traders who want to hold onto losing positions “until they come back” to the price they entered may never see it happen. A trader who has a 200K account short 1 lot of Hindalco Futures at 176, only has 50K of room before the account is drawn down to zero. Most people think they will never let a position go against them that far, but it does happen, and there is no assurance that the market will come back to 176 before it gets to 185, causing the trader to liquidate the position for a very large loss.
The simple solution is to never add to a losing position. However, as an experienced broker, analyst, trading newsletter publisher and individual trader, I know that is easier said than done. Here are a few rules to live by in order to help you stop adding to losing positions.
Place Stops Just Outside Normal Trading Ranges
When entering a position, traders need to give their positions enough room to work in their favor, but they also must have stops if the market moves decidedly against them. For a swing or position trader, this means having stops just outside the most recent trading ranges. It could be the previous day’s low/high, the past week, a 52 week high / low or right outside the natural support and resistance lines for the markets. Traders need to define this risk parameter BEFORE they enter the trade. Traders need to know what the risk is and make sure they are comfortable with the risk if they are wrong about the direction of the market.
Mental Clarity Can Only Be Achieved After the Losing Position Is Exited
When a trader is in a losing position and the market keeps on going against them, it is very difficult to approach the situation with a level head and clear mind. The fear of losing money can be the greatest factor in the psychology of trading. It causes traders to see things irrationally, as they do everything possible not to take a loss. This leads to poor decision-making and bad judgment. This is why it is so important to define the stop loss parameters before you enter the market and stick with it. (Subject to exceptions).
If possible, try to imagine you are flat instead of in the position. Then ask yourself, if you were flat, would you get back into the position? If not, you need to get out, and get out fast. If the trader can’t honestly say what he would do, or can’t detach from the situation, the best thing to do is exit. Getting out of a loser relieves stress and allows the trader to approach things with a level head. Once the trader is out of the position, he can always get back in if he feels it is the right move. Some traders don’t like this method because they don’t want to spend the extra commission for getting out and getting back in. However, the clarity that is gained from exiting a losing position is invaluable compared to the extra transaction costs. Don’t worry about a few hundreds when thousands are at stake.
You Must Be Able to Admit When You Are Wrong and Take a Loss
Being able to admit you are wrong and take a loss is the first step in the journey of successful trading. No one is perfect in trading. Taking a loss is a minor victory in trading. Being able to let winning trades run and exiting losers for a loss is what it is all about. However, you can’t get to the winners if you don’t take losses.
It is OK to be wrong. Actually, it is great to be wrong. Why? Because if you can’t be wrong, you’ll never be right about the markets. Trading is about taking risk and managing risk. The trader who can exit a position going against him is giving himself the change to win big on the next opportunity.
The Best Traders Add to Winning Positions & Use Stops to Protect Profits
The most successful traders not only cut their losers, but they let their winners run and add on as they go in their favor. They never average down losers, but they will certainly average up on winners. While some might not want to trade multiple lots, I think the concept is very important. When you have a winning position, the market is telling you that you are correct. The collective sum of all knowledge in the market place is in total agreement with you. This is the perfect time to add on another lot if you have the available capital without over-leveraging your account.
Some traders don’t want to add on at higher prices because it adversely affects their cost average. However, what traders need to realize is that markets trading higher tend to trend higher, and the opposite is true for bear markets. If you find yourself in a great winning trade, and you see no reason why it should stop, that is a great time to add on. When it comes to trading, you want to buy high and sell higher, or sell low and buy lower. We are not in the business of picking bottoms and tops. It is a one-way ticket to trading failure.
Successful traders also use stops. As the market moves in their favor, they move their stop up to where they feel is below a reasonable support level. They are comfortable with the losses or profits they will take if they get stopped out. They let the market tell them if they are right or wrong and they accept the market’s decision!
Find an Advisor Who Can Help You When You Need It Most
If you are having difficulty with adding to losing positions, you need to talk to your advisor about it. Regardless if you are a self-directed online trader or broker-assisted, you need to have a talk with your advisor. If you don’t have the advisor with your current trading arrangement, consider finding a one somehow who will allow you to access him regardless of whether you are a self-directed online trader or broker-assisted trader.
As a Senior Trader and advisor, I can honestly tell you from first hand experience how important it is to be able to work through these situations with someone who has an interest in the success of your trading. Sometimes we are able to offer valuable advice about not adding to losing positions. Sometimes it just helps for the trader to talk about the trade the same way a person tells their psychologist their problems. In the end, it is the trader who works out what needs to be done just by communicating the situation aloud to another human being. Either way, having a trained professional in the weeds next to you during battle can make a huge difference in your most difficult trading periods, and help you make sure you never return to that place again.
All The Best14