TPS E19: Why Averaging a losing trade can destroy your trading account?

As we’ve talked about so far, the most important thing you can do is keep your risk to an absolute minimum. I can’t say it enough. Minimizing your risk is 100 times more important than finding winning trades. (And finding winning trades is important too, so I hope this shows you how important it is to limit the risk.)

Then there is the habit that some traders get into that can be very detrimental to your trading. There is nothing that can add more risk to your trading than adding to a losing position. But nevertheless, traders do it every single day. The main reason this happens is the same reason most other trading problems come up. Most traders do not want to admit they’re wrong. By adding to their losing position, they give themselves another chance to not be wrong.

But if the key to successful trading is keeping the risk to an absolute minimum, then how can adding to a losing position help a trader? The answer is it can’t! This is very similar to what we talked about in Episode “Worst Mistake You Can Make”. The real problem is when averaging (adding to a losing position) works out and you end up taking a profit on a trade like this. This validates a very dangerous situation and could possibly tell you it’s O.K. to do it again next time. But the next time could be the time it takes a big chunk out of your account.

“The only reason to get into a trade is if you see an opportunity and you feel the market has a good chance of moving in your direction. But the reason people usually add on to their losing positions is not because they see another opportunity, but because they don’t want their first opinion to be wrong.”

I Repeat:

The only reason to get into a trade is if you see an opportunity and you feel the market has a good chance of moving in your direction. But the reason people usually add on to their losing positions is not because they see another opportunity, but because they don’t want their first opinion to be wrong.

They feel if they average out their price, they have a better chance of not being wrong. But, in my opinion, that’s the wrong attitude to be successful. I really feel most people add to their losing positions to avoid having to take responsibility for being incorrect about the current market direction.

I don’t want you to get the wrong idea. I don’t think scaling into a position is the wrong thing to do. If you have a plan to put on more than one contract at different price levels, I think that’s fine. But what I’m talking about is when a trader doesn’t have that kind of plan. They simply decide to add to the position as it’s going against them. This is a mistake.

And like I said a minute ago, it could turn out to be an even bigger mistake if it works out, because that situation tells you it might be O.K. to do it the next time. And I promise you it will hurt you much more than it will help you. I’ve seen it happen thousands of times. I’ve done it to myself enough times to know it will not work out in the long run.

Now, on the other hand, I don’t have any problem at all adding to a winning position. In fact, I think in many cases adding to a winning position is an excellent idea. I guess the basic idea is it’s O.K. to add to your position when things are going your way, but it’s not O.K. to add to your position when things aren’t going your way. That is a good rule to have.

Again, this just goes to the idea of acting in your own best interest. And, if adding to a losing position is a way to avoid admitting that we were wrong about market direction, then it would just go to show you that doing it (without a plan) is simply not acting in your own best interest. This is because if we want to act in our own best interest, we must be willing to admit that we are wrong, instead of avoiding it and making things worse.