Food for Thought

There is much discussion in trading circles about whether it is “good trading practice” to add to losing positions. Conventional wisdom in trading is to cut your losses quick and let your winners run. In principle this advice is sound and is no doubt followed by many traders. But as traders gain proficiency, the question becomes more complex than it seems if we strive for optimum trading performance. In reality, the question of whether or not to add to a losing position in forex trading becomes a matter of position management, and has a great deal to do with two factors: position size and probability.

Generally, the larger a position assumed initially in entering a trade, the less tolerance a trader will have for movement against his position. Therefore, when entering a trade with a larger position, it becomes more critical to have movement in favor of the position or only minor movement against the position. But we all know that “tops” as well as “bottoms” can be very difficult to call accurately and even entries in the direction of a strong trend can result in temporary reversal. Most traders have entered trades with a reasonable stop-loss only to see their stop-loss triggered almost exactly before reversal. Such losses can be costly especially over the long term. In forex trading, we are dealing with probabilities. Markets, as a whole, are bound in channels perhaps 80% of the time and for this reason the probability of retracing movement in both directions is often good. And because markets are fractal by nature, this applies to all time frames, including that of the forex swing trader and as well as the scalper. Hence there are many instances in which the probability of adding to a losing position and experiencing a winning trade considerably outweigh the probability of that trade resulting in a loss. The question of “adding” should therefore be examined more closely in the context of common circumstances encountered in real-life trading.

As we enter a trade, we should have decided beforehand our target price for exit of the trade as well as the range we will allow the trade to move against us before a stop-loss takes us out of the trade. This range may be called the allowable range of resolution for the trade.  Many traders fail to realize that if they enter a trade with a position greater than one lot and the position moves against them, they have in effect already “added” to a losing position from the outset of the trade. In many cases by entering with a larger position initially, the trader denies himself the option of adding to a position without excessive risk. The probability of a profitable trade is reduced if the market moves against the position before reversing, especially if his stop-loss was tighter than it would have been had he entered with a smaller position. This is since adding to a larger losing position carries greater risk than adding to a smaller position. On the other hand, if a trader enters a position with smaller size and it moves against him he has the option of allowing a wider range of resolution, i.e., a wider stop-loss. In addition, if there is nearby support (in the case of a long trade), the trader can add to his position and possibly see a reversal in his favor.  Thus if smaller size is used when entering a trade initially, then often “adding to a losing position” becomes “scaling into a winning trade”. It is this concept of “scaling in” as a premeditated strategy that can prove beneficial to many traders provided they use smaller size initially and enter at price points where the probability of reversal is in their favor. Many successful dealers, marketmakers, and individual traders use “adding” at multiple price points as a form of diversification of risk, rather than enter initially with the full size of their intended position at a single price point.  It is the discipline required and the correct circumstances in which to apply this practice that must be understood. The question then becomes “How and when should traders add to a losing position?”

The Role of Position Size

The dilemma faced by traders when the market moves against them stems from a reluctance to abandon a position only to have it reverse shortly afterwards leaving them with a “stop out” loss instead of a profit. Entering trades with excessively large positions, or “overtrading” is known to be the downfall of many a trader. The key to successfully adding to a losing position is to undertrade, i.e., to trade with smaller than customary size as an integral part of the trading plan. When scaling into a trade with successive smaller entries it is important to assess the relationship between position size and trajectory to profitability or the number of pips the price must move in favor of the position to secure a profit. As this trajectory is inversely proportional to total position size, the greater the position increments at initial entry, the more distant will be the point of reversal from the profitability threshold if the market moves against the position.

On the other hand, using several modest entries at different price points in place of a larger initial entry has two advantages. First, it limits the drawdown inflicted over the course of the movement against the position. Second, it allows a trader to exit with a profit even if the exit point is lower than the original entry point. Stops should always be placed once the intended position size is taken. If the market moves in his favor from the outset, traders may either add “on the way up” or remain with the original entry and obtain a smaller profit. It is far better to enter with one lot, add 2 subsequent lots, experience reversal and book a winning trade than to enter initially with 5 lots and suffer a loss when the market moves against the position and triggers a stop-loss. Thus the success of “adding” depends to a large extent on limiting the original entry size and on exercising discipline in adding to the position, i.e., adding size in small increments and only when adding is warranted. For many traders the use of a “mini” forex account is an excellent means of putting this concept of progressive entry to practice, as the risks of trading “minilots” are far less than that of trading with full lots.  But knowing “how” to add is not enough. Traders must also know “when” to add.

The Role of Support and Resistance Points

Adding to a losing position is not always appropriate. It should only be done if there is a concrete reason for doing so. Resistance and support points provide a logical reason to add to a losing position, provided the points are located within a reasonable distance of original entry and do not violate a trader’s rules in terms of risk tolerance. Risking no more than one to two-percent of capital on a trade is generally considered prudent. As was stated previously, more modest size provides the trader with greater flexibility with regard to adding to a position. Awareness of nearby support/resistance points before entering a trade is always important, but it is crucial to traders who choose to add to a position as the market moves against them.

The strength of support/resistance points and regions appearing on the chart should be carefully observed in advance. Price support/resistance may be present in one or more forms, including trendline, fibonacci retracement, SMA/EMA, heavy congestion, and round number (“roundie”) support or resistance. While the presence of support or resistance increases the probability of reversal in favor of a position, there are no guarantees.  For this reason stop-loss rules should apply, as always, and why more modest initial entry is often the key to controlling losses. It is important to remember that adding to a position when it moves against the trade requires the discipline to never allow the trade to get out of control. Adding to the position should not take place out of a need to satisfy the ego, but rather when the nearby support and resistance points and market sentiment warrant adding, i.e., when these present a good probability of reversal in favor of the trade.

The Role of Market Context and Sentiment

In forex trading, understanding the role of market context and sentiment is crucial. Market context may be defined as the recent events surrounding a currency pair’s price action, including  “fundamental” news events as well as technical events, such as breech of support/resistance or the repeated failure to do so. Sentiment may be defined as the frame of mind, or degree of optimism/pessimism exhibited by market players at large. Context creates sentiment, which at the extremes can result in apathy (basing markets) or feed on itself and culminate in panic (wild volatility). Sentiment should be a key factor in forex position management decisions, as it is in trading other markets.

One of the first considerations in forex position management should be the direction of the prevailing trend. This is since adding to a position against the broader trend carries greater risk than adding in the direction of the trend depending on the timeframe intended for the trade. A “channeling” market provides a greater probability of reversal while trending markets provide a greater probability of continuation. The position of the price within a channeling market must also be carefully assessed with respect to the intended trade timeframe in making position management decisions.

As forex price movements are to a large extent driven by news events and technical milestones market context and sentiment are in near constant flux. In forex, sentiment can be classified as one of two types: casual sentiment and critical sentiment. These should be recognized and understood by traders. Casual sentiment occurs when the latest news events have already been incorporated into prices and violent movements have already played out. Casual sentiment is characterized by greater calm and “drifting” price movement. Casual sentiment occurs during quiet forex market hours and especially during periods of lower volume. During casual sentiment it is more common for support and resistance points to be respected, though they are often tested. Adding to a position that has moved against us is generally less risky during casual sentiment, so long as support or resistance is present.

In Forex trading, casual sentiment can become critical sentiment at virtually any time. During periods of calm, casual sentiment can suddenly turn critical if major players decide to take advantage of low volume to move prices and thus create a critical environment. More often, critical sentiment occurs during news announcements and is characterized by volatile market movement.  It generally results in high volume and is accompanied by greater risk and uncertainty. Brokers sometimes widen spreads during critical sentiment to protect themselves from this uncertainty. During critical market sentiment support and resistance points are often broken decisively. Even successive levels of support/resistance are frequently broken resulting in an extreme price movement. Also, during critical sentiment, it is common for extremely large market players to deliberately attempt to trigger certain technical events, such as trendline breaks, breaks of key resistance/support, or “touching” widely held stop orders to induce panic and continuation of movement. Key option-related price points are also attacked and defended more often during critical sentiment. For this reason adding to a position during this sentiment carries far greater risk than during casual sentiment. It is not difficult to see why distinguishing between casual and critical sentiment is crucial to effective position management in forex trading.

Conclusion

The preceding concepts and ideas are presented in order to highlight and place in perspective some of the many factors associated with position management in forex trading. Though all traders should have rules, it is difficult to apply the same steadfast rules to all traders. The wildcard will always be the mind of each trader at the instant a decision must be made. The importance of the psychological element in forex trading is undeniable, since degree of skill, confidence, risk tolerance, emotional reaction, ego and stress levels among traders varies widely. In the end each trader must do what works best for him/her in the endeavor to find success.

Write Comment
Please keep the topic of messages relevant to the subject of the article. Personal verbal attacks will be deleted. Please don't use comments to plug your web site.. Such material will be removed
Name:	Guest
Title:
BBCode:
Comment:
	Enter what you see: * tips: hit Reload page before writing a text if you have difficulty reading characters in image

Powered by AkoComment 2.0! and SecurityImage 3.0.4