As Forex traders, it’s important to always look for confirmation before putting on a position. This is just as true when adding to an existing position as it is when putting on an initial position.
For the initial position, we can use patterns and levels combined with price action signals in the direction of the trend to provide confirmation. Also called confluence.
When it comes to adding to an existing position, you must have two factors in place: continuation of a trend and a break of a key level. The first factor is where many traders go wrong. Instead of adding to a position after the market has moved in the intended direction, they add to the position in hopes that the market will reverse so they can make back what they’ve already lost.
In this article we’re going to discuss the concept of averaging down and how it is arguably the number one killer of Forex accounts. We will also discuss the proper way to add to a position that can increase your profit potential exponentially.
What is Averaging Down?Averaging down is a popular strategy used in the financial markets. It’s most popular in equities, which is where I got my start. Although I never quite understood the logic behind adding to a losing position, many traders use this strategy to try and create a more favorable entry price.
Just as the name implies, averaging down is a way of adding to a losing position in hopes of creating a more favorable average entry price. So if you buy at 1.50 and the price drops to 1.40 and you buy again, your average entry price is now 1.45. This of course assumes that you are buying the same position size at both levels.
The problem with this strategy is that it ignores the most basic principle of becoming a successful trader – cut losses short and let winners run. There are several other issues that we will discuss in greater detail later in this post.
Never, Ever, Ever Add to a Losing PositionAs Dennis Gartman, editor and publisher of the Gartman Letter said, “never, ever, ever add to a losing position:ever!”.
The entire premise of becoming a successful Forex trader relies on cutting losses short and letting winners run. In fact I would argue that in terms of trade management, this is the most important thing you can do to secure your success as a Forex trader.
A losing position is a red flag. It’s a sign that your trade idea may not have been a good one. As George Soros said, “I’m only rich because I know when I’m wrong”. In other words, if the market moves against your position, especially for an extended period of time, it’s usually best to take a loss and move on.
A negative mindset breeds losses
Have you ever noticed how one loss tends to bring about further losses? This is because after a loss, your mindset turns negative. It goes to that place of fear, clouding your judgement about future trade setups. For this reason I’m an advocate of taking a break from trading if you find yourself on a losing streak.
But this negative mindset isn’t limited to realized losses. Unrealized losses in the form of a losing position can cause the same negative energy. Therefore adding to a losing position is essentially the same as opening a new trade immediately following a series of losses, which is a recipe for disaster.
There are ways, however, to scale into an open position in order to achieve greater profits. But no such way exists that entails adding to a losing position.
Capitalize on Positive PositioningThe only way to achieve greater profits on a single trade idea is to capitalize on positive positioning.
What does this mean, exactly?
It means only adding to a profitable position, also called pyramiding – a strategy that looks to capitalize on a profitable position by strategically adding additional positions. By strategic, I’m referring to adding positions once a market moves in the intended direction and breaks beyond the next support or resistance level.
The benefits of capitalizing on positive positioning are threefold:
1. You aren’t adding to a position while in a negative mindset. This allows you to properly evaluate the market so you can be strategic about adding new positions. With positive energy on your side, you can operate based on logic rather than fear, thus increasing your odds of success.
2. You are waiting for the market to confirm your trade idea. When you average down, you are increasing your risk without first having confirmation from the market. By waiting for the market to first move in the intended direction, the market is giving you a reason to add to your position.
3. You aren’t increasing your risk. When you average down, you are taking on additional risk due to the fact that you aren’t able to reposition your stop loss. However when you wait for the market to move in the intended direction before adding to a position, you give yourself an opportunity to minimize risk by moving your stop loss to a more favorable position as the market moves in your favor.
Final WordsThe advice to never add to a losing position cannot be overstated. It is far and away one of the most damaging mistakes a Forex trader can make, but it’s also one of the easiest to correct.
Will averaging down occasionally play out in your favor? Sure, just as you might occasionally make a profit if you blindly buy or sell a currency pair. But the damaging effects of adding to losing positions over a series of trades will far outweigh any positive impact it may have.
On the other hand, adding to a winning position through pyramiding is by far the most effective way to increase your profit potential. Just remember that the number one rule when pyramiding is to never, ever, ever add to a losing position.
