Never add to a loser. Never double down. These old trading maxims are treated as sacrosanct truths by most traders. What a bunch of nonsense. I add to losers all the time, and so do some of the most successful traders I know. Why?
Because what most books never tell you is that almost all trades start out as losers. It is extremely difficult to time the entry so well that it immediately begins to move in the direction of your trade. Sometimes trades will move only a few points against the position but occasionally prices may retrace several hundred points away from initial entry only to eventually turn around and become profitable.
Trading is the art of accurately forecasting direction and timing. Between the two, timing is far harder to handicap, especially if prices seesaw back and forth for a while before ultimately moving in the right direction. Traders who trade highly leveraged positions with tight stops will be eviscerated in such an environment, as they will continuously get stopped out. Far worse than the hit to equity is the psychological pain of “death by a thousand stops.”
That is why traders who do not like frequent stop-outs prefer the scale-in approach to price entry. This strategy is almost diametrically opposite to the strategy discussed in the preceding section. Using the scale-in approach assumes that the first entry will almost never be the best entry; as a result, the approach requires very low leverage in order for the strategy to withstand the adverse price moves.
In this strategy, the trader continuously adds more units as prices move against him, trying to achieve a blended price that remains near the current price. If prices do eventually turn, the constant averaging of price levels will make the position profitable much faster than if he expended all of his trading capital on the first price entry. While this can be a successful trading strategy, it can also be highly dangerous if the trader does not follow two key rules:
1. Set a hard stop for the whole position.
2. Trade in very small increments.
To understand just how destructive this strategy can be, let’s examine what happens if the trader uses this method employing the standard allocation of 2 percent of capital per trade. Imagine that the trader with a trading account of $10,000 initiates the first trade in the EUR/USD currency using two mini lots (worth $1,000 each). Prices move against his entry by 100 points and he now doubles his allocation to four mini lots. Again prices continue to move against him by another 100 points and he doubles his position yet again to eight mini lots.
Prices continue to follow this adverse pattern and move against him by 100 points more. Finally, the trader gives up and covers his position in dismay. What is his total loss? A whopping 22 percent of his total capital!
•$600 on two mini lots (prices moved 300 points away from entry).
•$800 on four mini lots (prices moved 200 points away from entry).
•$800 on eight mini lots (prices moved 100 points away from entry).
The irony of the matter is that after an uninterrupted 300 point move against the position, chances are quite high that the trade may turn around and could quickly become profitable. But by overleveraging the position the trader is unable to withstand the drawdown.
Imagine the same scenario but instead of using mini lots with the value of $1 per point, the trader uses micro lots with each point having a value of only 1 dime ($1,000). In FX, where many dealers offer such small lot sizes, this strategy is eminently possible. In that case the drawdown would be a far more manageable 2.2 percent of capital and the price would need to move back only 150 points instead of the full 300 points in order for the trade to become profitable.
This type of scaling where the trader doubles the size of the position at every interval is called “geometric scaling.” Unlike regular average-in scaling that cuts the break-even point by 50 percent, geometric scaling requires that prices retrace by only 33 percent to reach the break-even point. While this can be a very effective way to quickly make a losing trade profitable, the strategy can also spiral out of control. A better compromise between the straight average in method and the geometric scale-in is the arithmetic scale strategy. Instead of doubling up the position at every interval, the arithmetic scale calls for an increase of the position by a fixed amount. It shows the key differences between the geometric and arithmetic approaches using a hypothetical scale-in strategy in EUR/USD starting with entry at 1.2500 and a hard stop at 1.1950.
Note that in the worst-case scenario the geometric strategy loses more than $2,000 on a $5,000 account while the arithmetic strategy loses only $143. At the same time the break-even point on the arithmetic strategy is 1.2166, only slightly higher than the 1.2049 break-even on the geometric approach. The data clearly shows that for multiple-interval scale-in approaches the arithmetic strategy is the best bet.
Subscribe to:
Post Comments (Atom)
Post a Comment