As we covered in a previous Golden Rule, wishful thinking can be the undoing of a trader. One of the most common manifestations of this is the tendency for traders to keep adding to a losing position in the hope that a reversal will be forthcoming. With the price travelling in the wrong direction, traders place new trades to increase the profit from the upswing, or cancel out losses from trades that have stopped out.
Now, there is every chance that the trade will come good at some stage. The problem is that if you have added more and more to a losing position, the losses will mount to the point where you have to close out your positions at a huge loss, or hang on until you get hit with the inevitable margin call. In these situations, the original idea behind the trade has been proved wrong, and a good trader would have cut their losses and moved on a while ago.
But despite common sense pointing towards a different plan of action, many traders ignore rationality and find themselves adding to a position long after they have been proved wrong on their original trade idea in the hope that, somehow, the trade will eventually go their way and all their losses will be cancelled out. This can occasionally happen, but it doesn’t happen often enough to be considered a viable trading option.
This type of behaviour is analogous to a roulette player using the Martingale strategy., This is the process of doubling the bet after each losing bet so that the next win cancels out all previous losses. Sounds foolproof, but the problem with this strategy is that once you have a few losses in a row, the bet will get so big that you risk losing everything, or you will hit the table limit and the strategy won’t work anymore. The same applies to adding to a losing position – it’s just a bad strategy.
Scaling in VS Adding to a loser
In most cases, adding to a losing position that has passed the point of your original risk tolerance is also a bad strategy. However, there are some scenarios in which adding to a losing position can be a good strategy, and this technique is known as scaling in.
The difference between scaling in and simply adding to a losing trade lies in your initial intent before you make the trade. If you intend to buy a total of 100,000 units, and you split this into 10 smaller trades of 10,000 units each to get a better average price, you would describe this as scaling in. This is a popular strategy among traders who are looking to buy into a retracement of a bigger trend, and are not really sure of how big the retracement will be. The trader will then scale down into the position to get a better average price.
The most important thing with this strategy is that the staggered approach is the original intention rather than an afterthought or a reaction, with an ‘ultimate stop’ on the entire position that you then stick to. This is the main difference between scaling in and and adding to a loser.