The important (and avoidable) trading mistake that is commonly seen occurs when traders “average down” and holding onto losing positions for much longer than they should. In fact, there are some key similarities between the traders that make this mistake and those guilty of having unrealistic expectations (one of the cardinal sins of day trading).
Imagine that you enter into the forex market expecting to make a fortune in a few days or weeks. You get a “hot tip” on a trade and enter into a highly leveraged position. Then, the unthinkable happens: The market begins to move against you and your position begins to lose money. Immediately, you begin to question the situation you are in, rather than the decision you made. How can I possibly be losing money? I thought I had “good information” that this currency pair would move in a particular direction. Is it possible my broker is conspiring against me? Should I just stay in the trade until it starts to work in my favor?
Asking Yourself the Right Questions
These are all very common questions asked by traders in the early stages of their careers. Unfortunately, none of these questions is the right one. More appropriate questions should have a more inward-looking view. “Instead, this trader should be asking different questions,” said Haris Constantinou, currency analyst at TeleTrade . “What mistakes did I make when I constructed this position? Am I overly leveraged? Is it the right time to just cut my losses and close the trade?”
The difference between these two types of questions should be clear. The former (and inaccurate) line of questioning involved blaming other people and expecting the market to conform to your trade. The latter line of questioning requires the trader to look at potential mistakes and to manage the situation in an intelligent and conservative manner. When trading problems occur, it is never a wise idea to simply blame the market and suggest that the trading majority is incorrect. It is much more prudent to look inward and identify the trading factors you incorrectly believed would result in a different market outcome.
What many trader try to do in these cases (once they are in panic mode) is “average down,” or add money to the position once the market is moving in the opposite direction. While this strategy does have the added advantage of improving your average price (since you would be buying lower in long positions or selling higher in short positions), the fact remains that you are adding to a losing trade. This can become particularly destructive for your trading account if you are doing it for the wrong reasons. For these reasons, it is important to take the broader market context into the equation, rather than simply relying on this form of trade restructuring as a magic bullet for all situations.