Here is the fourth part of our 7 part series titled “The 7 Deadly Financial Spread Betting Mistakes”. Today we will discuss the fourth of the 7 financial spread betting mistakes that financial traders make:
Mistake #4 Averaging down (adding to losing trades)
This is one of the biggest mistakes that financial traders make and it is the downfall of many traders and trading systems. Many traders think it’s a good idea to add to a losing trade as they think that if they take a second position they are averaging down their price. In rare cases this might actually work, but in most cases it will go against you and in fact creates a snowballing effect, whereas now instead of having a single small loss, you now have 2 losses.
Now you can find yourself getting into real trouble by opening a third and a fourth unit. Before long you have a huge position open which is way out of balance for your account and much too risky. These trades often go wrong and when they do they wipe out all of your trading capital. The only real effect of adding to losing trades is an increase in risk.
The right thing to do when a market goes against you is to just get out of the trade when it is clear that you are wrong. A good trading system should have specific rules for defining when to exit a trade if it goes against you. This leads to taking the occasional small loss, but is not emotionally or financially damaging and leaves your trading capital intact for when the market is right and sets you up nicely to take advantage of the next big move in the market.
To be clear, a unit is the position size that you have open. In futures trading this would be the number of contracts that you opened on your original position. In financial spread betting a unit would be the bet size per point that you had opened on your original trade.
For example, let’s say that you are using financial spread betting and that you have opened a trade at £5 per point. Adding a unit would mean that you opened a second position in the same direction (either long or short) for another £5, meaning that you would be either net long (or short) £10 per point. Each additional unit would then be another £5 per point, so you can see how you can quickly build up a large position with a lot of exposure.
Most traders take too much risk in the first place and then compound that mistake by adding more and more trades as the trade goes against them. This is why you hear some horror stories about amateur traders dabbling in the markets and losing their shirts. Adding to losing trades is fatal to your long term profitability as a trader.
Not quite as bad but also very destabilizing to your profitability as a trader is adding to winning traders. Many so called trading gurus will tell you that you should add units to winning trades. I believe that this is also a mistake and is poor advice and here’s why…
In my earlier days as a trader I used to add to trades that went in my favour. This is all well and good when things are going well, but what I found would happen was that I would pyramid up my position and get up to about 4 units on a trade, only for the market to reverse and cause me to take a large loss. This can be very frustrating, especially as oftentimes if you had just left your single trade on and had not moved your stops up behind the market as you added on units, you would still have been in your original trade without your stops being hit.
One of the major drawbacks with adding on multiple units is that you either leave a very wide stop loss, or you move your stops up behind the market. Moving stops up behind the market can often cause you to get stopped out of the trade on a small reversal, even though the trend is still in process.
After extensive back testing over a 25 year market history database, I proved to myself that adding units on to trades is a mistake, whether you are adding units to a losing trade or a winning trade. Adding units to losing trades inevitably causes your account to eventually go to zero, as sooner or later you will end up taking a huge loss. While the effects of adding units to winning trades are not quite so damaging, I found in every test I made that the profitability of the trading system actually went down, while the risk profile increased.
The LS Trader system takes all this into account and only trades single units. The LS Trader System does not add to losing or winning trades, therefore keeping the system stable without too much exposure to risk. Even with just one single unit per trade, the LS Trader system is extremely profitable.
In essence, a trading system that adds units is less stable, prone to larger and more frequent drawdowns and has a higher risk exposure. This is not the way to trade successfully. Stick with a single unit. If the trade goes against you then you should exit with a small loss and live to fight another day. If the trade goes in your favour, then hold it for the duration of the trade. You will still make more than enough profit from the occasional big winning trade to pay for all your losses and still leave enough over to make a handsome profit.
This leads us nicely on to Deadly Online Trading Mistake #5 which is titled “Taking too much risk”. This will be published here in the next few days.
Until then, good luck in your trading.