Signs That Averaging into a Trade Is Not a Good Idea
Many trading books recommend avoiding averaging into, or adding on to, a losing position — and with good reason. The tactic can lead to dramatically higher losses on smaller incremental price movements. Also, if you’re adding on to a losing position, you’re missing out on the current directional move. In other words, not only are you losing money, but you’re also not making money, which is the opportunity cost of averaging.
But that still doesn’t stop people from averaging into losing trades, even professional traders. Here are some indications that averaging is probably not a good idea:
The market just blew through your stop-loss level. But you didn’t have a stop-loss order in place, so you’re still holding onto the losing position. First tactical error: Trading without an active stop-loss order.
Second tactical error: Instead of exiting the position in line with your trade plan, you’re reluctant to take the larger loss than you initially reckoned with, so you decide to hold on to the position, hoping it will recover.
This is usually the first wipeout on the slippery slope of relinquishing trading discipline. Save yourself some money and don’t commit a third tactical error by averaging into an even larger position (which you had already planned to be out of by that point anyway).
The range just broke. You may have had great success in recent trades playing a range-bound market, and you’re in a position again based on that range. But ranges do break, and prices do move to new levels. Remember the basis for your trade — the range is going to hold — and don’t hang on, much less add on, to positions beyond your predetermined stop-loss exit level based on the range.
News is out, but the currency pair is not responding the way it should. The news or data may be USD-positive, for example, but the dollar is coming under selling pressure anyway.
Keep in mind that multiple cross-currents are at work at any given moment in the forex market. Sometimes they’re position related (a large hedge fund may be turning around a multibillion-dollar position); other times they’re based on news or information that is not widely known in the market, like a mergers-and-acquisitions (M&A) deal or a rumor.
The market reaction to a news/data report is more important than the report itself. If you’ve taken a position based on the news, don’t second-guess the market reaction by adding on to the position if the market doesn’t respond the way you think the data indicates. Instead, accept that something else is going on and that the news you based your trade on is not it.