Trading Psychology For Dummies
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You can adjust your trading position if new information suggests a stock market trade isn’t as strong as you originally thought. Often, when you’re using multiple trade indicators, you don’t get a clear-cut trading decision, or as the trade progresses, one of your confirming indicators weakens and is no longer offering the comfort of full confirmation. You can adjust positions from the beginning of a trade or when indicators spell trouble:

  • Start a new position by placing the first trade for one-quarter or one-third the amount of money you plan to place in that specific security and add to it as confirming indicators come in.

  • Reduce the size of your position when warnings arrive from indicators.

Reducing positions

The safest way to reduce the risk of loss is to reduce exposure to it — start scaling out (reducing the amount you have at risk). If you bought on an indicator-based signal but you think you know of a fundamental reason why it’s not going to be a good trade, the two conflicting ideas may cancel each other out. Similarly, you may have a nicely trending security and get a surprise stop hit that you don’t trust because you think you can identify the cause as an anomaly. Instead of being paralyzed or not trading at all, you have a few options:

  • Delay following the indicator signal until the nontechnical event risk is past. Some traders advise reducing (or exiting) positions ahead of known event risks, such as central bank meetings, earnings announcements, and national elections.

  • Stay in the trade, but reduce the amount of money you allocate to it (and perhaps tighten the stop). You can also hedge the risk in the options market or by taking the opposite position in a correlated security, but on the whole, scaling out is the most direct and efficient method.

Adding to positions

You can add to a position, or scale in, when your existing position is highly profitable. Statisticians debate whether you should add to winning positions by using unrealized profits from the existing trade, called pyramiding. To pyramid is to use hypothetical profits to enlarge your position.

Why not borrow against the hypothetical profits to buy some more of this high-performing security? If a catastrophe strikes and the trade goes against you, your risk of loss can become huge — more than your original stake if your stop fails (or, heaven forbid, you didn’t place one). Be aware that if you engage in pyramiding, you’re taking a higher risk than if you don’t.

Techniques for scaling in and out

Techniques for scaling in and out include

  • A 2 percent stop rule: When the existing position has gained a profit that’s greater than the 2 percent of starting capital you’d have lost if the stop had been triggered, add the amount of the surplus profit to the position with its own 2 percent stop.

  • Using margin (where the trader puts down only a fraction of the value of the contract being traded): Add to the position when the existing trade has earned the cost of the minimum initial margin of a second position. If you’re trading on a 50 percent margin, you add to the position when the existing position has racked up enough paper gain to fund the new position.

    This rule is especially valuable in the futures market, in which the trader puts down only a small fraction of the value of the contract being traded. For example, if the initial margin required by the exchange and your broker is $2,500, you don’t add a second contract to your position until the first contract has a profit of $2,500. By then, you figure that the move is well in place. But remember, you have to have one stop-loss order on the first contract and a different one on the second trade.

Applying stops to adjusted positions

If you’re using an indicator stop and it signals that the price rise is over, doesn’t that mean you want to exit all positions at the same level as soon as possible? The answer from statisticians is “maybe.” It depends on whether you’re thinking in chart terms or money-management terms:

  • If you’re using a breakout concept to set your stop, for example, the price crossing a support line is a sell signal that would apply equally to all positions.

  • If you’re using a 2 percent or other rule (like the chandelier exit) that’s calculated specifically with reference to your starting point, you exit each trade according to the rule.

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