So there you are……you’ve done your homework……and taken the trade. You found a great spot for entry, all signals were go, and you entered the market. Within a few minutes of getting in the market though, you find yourself in drawdown. You have a 50 pip stop and before you know it, you are half-way there. You think “Well, if I thought my initial entry was a good price to get in, I should really love where the market is now and take another order.”
Yeah…. the ol’ “dollar-cost averaging” philosophy.
Although this works great much of the time when you are investing based on fundamentals over the longer-term, it can be a seriously risky maneuver when trading based on technicals in the short-term.
When I started trading forex, I had the unfortunate experience of having VERY good results right at the beginning.
Why was this unfortunate?? Aren’t gains good??? In fact, I tripled my account in under 2 weeks of trading. What this experience set me up for though, was the confidence in my abilities that I did not actually posses and the willingness to take risks based on that assumption. After all, I had always done very well in equities buying on dips that scared away everyone else. In fact, I had been handsomely rewarded for aggressively buying stocks when the market crashed in the Fall of ’08 when I bought so many different sectors when everyone was looking for the door. I stopped buying in March of ’09 and rode my gains for some time and cashed out.
When I entered the forex trading arena, I had not been sensitive the changes I would need to make in the conversion from investing to trading. So there I was, with my first live forex account tripled in two weeks and I was ready to make more. I found myself with a losing position on the Usd/Cad and I decided to add another position since it was clearly at a better price than my initial entry. Not using any stops, I kept adding positions as my orders kept losing assuming that the pair would have to turn around. I watched my open, floating drawdown quickly increase as the pair continued to move against me. It never turned around.
Finally after a gut-wrenching 6 hours of watching my account dive deeper into the red (floating profit), my broker closed my losing trades before the account was fully “blown-out”. Yup, I vaporized 80% of the account in one night of reckless trading. That was almost the end of my forex experience and it took me 3 months before the word “trading” didn’t come with a bitterness and anger in my heart. It took A LOT of learning and experience with different strategies and systems to figure out exactly the depth of my bad trading on that fateful night so early in my forex career.
One of the things I learned from it, was although the “dollar-cost averaging” principle works pretty well in investing, you actually need to think completely opposite when it comes to successful day trading. What I am driving at here is rather than adding more positions to losing trades, you should be adding more positions to winning ones! There are two primary factors at work here:
1. The Trend is Your Friend
The fact is that usually when you get your first entry right, and go into profit, you actually tend to do better than when the order goes against you.
Much of the time, when you get the direction of movement right, it will continue for some time before making a reversal.
Rather than fighting the direction of the market in the near or mid-term, you are going with the flow of the market.
2. Risk, Risk, Risk
The MOST important factor here is how much total exposure to risk your account will take assuming the worst-case scenario. By adding a new order when you are already in profit, you have the option to move your original stop to b/e or better, therefore eliminating your original risk and potentially only risking your newest order or even less than that in the case of a chain of orders of more than 2.
On the other hand, when you add a new order to one that’s already losing, you are simply adding more risk without eliminating any. Sure, if price turns around it is easier to reach overall b/e than if you hadn’t taken the second or third, etc… order, BUT if price doesn’t turn around you get hit for full risk on every single order. That can equal a big total loss.
Let’s look at a quick example to illustrate my point. Let’s assume trader #1 adds one order each 20 pip move against their original position while trader #2 adds one order for every 20 pips in FAVOR of their original position. Both traders are using a 50 pip stop for each order and a 50-pip take profit. Each order will risk 2% of the account. Max of 3 orders.
- Worst Case Scenario: Trade goes against position, 2nd trade is taken, then trade continues towards stop loss, so 3rd position is taken. Our total risk is 2% X 3 positions for a total of a 6% loss.
- Best Case Scenario: Trades go against trader, but just enough to get 3 positions into the market and then market goes into full t/p for each of the 3 orders. Total risk is 6% but gain is 6%.
- Alternate Scenario: Trade just goes into profit without drawdown. 2% risked for a gain of 2%.
- Worst Case Scenario: Trade goes against initial order all the way to stop. 2% risked, 2% Lost
- Best Case Scenario: Trade goes in favor of order, second trade is taken and first stop is moved to b/e, and then trade continues in favor to 3rd order which now places first stop at second order b/e. Total risk=0% Total gain=6%. Keep in mind, that the worst possible risk at any time during this process is 2%, but never more because new orders are opened, older orders are adjusted.
- Alternate Scenario: Trade just goes into profit, all the way to the third order, and then reverses and stops everything out. Total Risk=2%, Total Loss=little more than 1% (1st order is +20 stop at third order opening, 2nd is b/e stop, and 3rd has the risk of full s/l)
So in the case of the two traders, you can see that in the market conditions being relatively the same, the first trader has a max risk of 6% and a minimum risk of 2% EVERY TIME. Trader two on the other hand has a max risk of 2% and a minimum risk of 0%. That right there should be enough.
Now let’s get more extreme and imagine a 300-pip move for both traders with no limits on how many orders they can open.
You can see trader 1 is ALWAYS adding more risk by adding new orders while trader 2 is ALWAYS reducing risk by adding new orders. Trader 1 is fighting against the prevailing movement of the market while trader 2 is always going with the movement of the market. And think about this, by the time trader 2 is on their 4th order, they are guaranteed some sort of a win, while trader 1 is risking 8% of their account and has a ways to go before overall b/e.
No matter what, trader 2 never risks more than 2% in ANY market conditions, while trader 1 has risk only limited by the number of order they are willing to place. Of course, whipsaw markets can affect the outcome of either trader, but the risk is guaranteed never to be more than 2% for trader 2 and trader 1……better hope for ideal conditions. Ask yourself this “Would you rather only ever be on the hook for 2% to gain potentially much more, or would you rather risk a % to make that same percentage back in the best case scenario only?”
So I now know to add to winners, and just let my losers go. Although this may fly in the face of good investing, day trading requires not only a new set of tools, but a new psychological approach as well. Pyramiding when you are winning can greatly enhance your gains while never adding risk, while doing this when you are underwater adds extra risk without compensating you adequately for it.
Author: Omar Eltoukhy. Omar has a wealth of investing & trading experience as you can see from his biography ABOUT OMAR
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