If you speak to a wide variety of traders and ask them what their number 1 rule is, adding to losers is probably right near the top. The number one rule is probably cutting losses, which we covered in the previous article. Adding to losers, also known as averaging down, is a key ingredient into the recipe of disaster for traders that is large losses.
The first thing to understand is why traders feel compelled to add to a losing position.
Usually, traders hold on to trades that are going against them for two reasons :-
i) They don’t want to be wrong (e.g. a knock against their ego)
ii) Fear of losing money
Now we all know that losing is just part of the game, it can’t be avoided. However traders still routinely see themselves unable to not only cut losses, but increase risk and take on further positions. The logic behind this is that traders can essentially bring down their average entry price on the trade.
For example, let’s say a trader goes long on GBPUSD at 1.500 for £10 a point. The price then falls down to 1.4950, so at this stage the trader is 50 pips in the red. If the trader enters a second long position here at £10 a point, the overall average entry price has been reduced from 1.5000 to 1.4975. Thus for the trader to move into break even, he only needs an up move of 25 pips, not 50 pips which is what he is in loss from the original position. Anything over this will have the trader in profit on the overall trade.
On the face of things, this may look like it’s a good idea… so then why should traders NOT add to losing positions?
Essentially, when you take a trade and it is not working out, that is just the market telling you that in this instance you are wrong. You may have followed your plan perfectly, but sometimes trades just don’t work out. If you as a trader continue to hold onto a losing position after you have a clear indication from the market that you are wrong, you are effectively arguing against the market as a whole. By not closing the trade when you know you are wrong, you are reinforcing the myth in your head that the market is wrong, and you are right. This is not the mindset you want to be in!
What makes matters worse, is that not only do you not submit to what the market is telling you and close your positions, you have just doubled up in the wrong direction! You have doubled your leverage on a losing trade.
Now, the issue traders have, is that unfortunately sometimes bad behaviour is rewarded. Undoubtedly most traders in their career have had a situation where they have moved or removed their stops, or they have averaged down and it has worked out. This is pure luck and nothing else. We feel good about it in the short term, however in the long term two things happen:-
i) This bad behaviour is reinforced due to a positive outcome for us
ii) There will come a time when our luck runs out and we blow our accounts. It is a game of Russian Roulette, and we only need one to go against us before it’s all over…
The absolute best thing you can do is to never add to a losing position. Before you take each trade, determine what you are willing to risk, and truly accept it. That way, you know the worst scenario of each trade before it happens, and more importantly, you are OK with it!