Disclaimer: Not trading advice.
If you go to YouTube and search for trading videos, you’re sure to find plenty of videos with titles like “Top 5 Rookie Trader Mistakes And How To Avoid Them“, or “WINNERS ADD TO WINNERS! 🏆” One of the most common “rules” internet trading gurus preach is “never add to a losing position”. This will usually be accompanied with similar golden nuggets of advice such as “cut your losses and let your winners run”— which is great advice provided you possess a time machine so you can find out in advance which trades will be your winners and which ones your losers; but why is “never add to a losing position” bad advice? It sounds logical. After all — if you’re in a hole you don’t keep digging, right?
Let’s suppose you’re trading stock X. You believe in stock X long term and believe it will go higher. And you have good reason to believe this. Stock X has been performing very well for the past few months, and its fundamentals are sound.
Let’s suppose you buy 10 shares of stock X at $100 per share. Soon after that, the price of stock X falls to $99. Your trade is now technically “losing”. do you close it?
Maybe stock X is just having a small pullback. Maybe it would be a good idea to add some more here, after all, you’re getting it at a cheaper price, right? Yes. You are right. And this is how professional traders trade. They add to losers. And they think nothing of it because they know that those losing trades are eventually going to be winners.
Suppose stock X dips even further. To $90. Ask yourself the question: “Do I still believe stock X will rise long-term?”. If the answer is yes, then you buy. And congratulations. You’ve just bought stock X at a $10 discount. Suppose you buy 10 more shares at $90. What’s your average entry price?
(($100 × 10) + ($90 × 10) ) / 20 = $95
See that little dashed horizontal line on your chart? That’s your average entry price. Some trading terminals have it and some don’t. For example MetaTrader 4 doesn’t but you should be easily able to find an indicator that calculates and displays it for you. It depends. But if not, it’s easy to calculate it.
If the current ask price is below that line, you buy more. Yes. Even in a losing position. That makes the line go further down. The aim of the game is to get that line as low as possible.
Once the price goes back above it, congratulations! You are now a winner.
Should I Add To Winning Positions?
No. You should never add to a winning position because that will increase your average entry price. If you want to close your trade, that’s fine. Maybe you’ve had a good day and you’re happy with your profits. That’s great. The markets will still be there tomorrow.
What About Doubling (or Tripling) Down?
Never, ever, do this. In fact, when you add to a losing position, never add more than your initial risk. And give yourself plenty of opportunities to catch bigger dips. Increasing your order size as the price drops can get out of hand very quickly. I’ve been there.
Remember, if the price dips 50%, you can buy the same amount of the asset as you did in your original buy for half the price. If the price dips a further 50%, you can buy for a quarter of the original price. Spend the same amount or less buying each dip.
This Seems Like Simple Common Sense, But Why Don’t Traders Do This?
Professionals do. Professional traders do this all the time. It’s known as “Scaling in”. Sometimes you know the market will go up, but you don’t know when, or by how much, or how much it will go down by before it goes back up again. Professional traders don’t know these things either. But they somehow manage to make money.
Professionals also don’t add to winning positions. This seems counter-intuitive, especially to the aspiring retail trader who learned how to trade from YouTube. But adding to a winning position increases the likelihood of it becoming a loser in the future.
I Have a Winning Trade, but What About Dips?
So here’s a situation: you have a winning trade, a nice dip has just happened, and your trade is still in the green (even after dipping) and you want to buy it. Do you buy? Here’s my advice: buy it if you think it’s a good opportunity, but buy it as a new position so you can keep track of it separately, and make sure you use adequate money management.
But remember this: you’ve got a better position open already so if you’re risking more money in this new trade then you’re risking more for less. If you feel you must open a new trade, make it smaller. The goal is for your big trades to have the low entry prices.
Sometimes a trade will go your way right away, and you can soon close it out in a profit, but other times the trade will go against you and you need to “manage” it. Sometimes your best trade is the one that initially goes against you, but then comes good. Have patience. Sometimes there’s nothing you can do except wait.
Trading is boring. If you find yourself feeling excited whilst trading then something is wrong.
- Adding to losing trades is good, provided the market is bullish in the long term.
- Adding to winning trades is bad, despite what some guy on YouTube told you.
- Use adequate money management.
And don’t risk what you can not afford to lose.