Fseitun, I find this to be an extremely valuable post. I am still in the beginner stage as a trader and fight certain demons a lot. I will do very well day trading with strong risk management strategies, then I'll throw in some riskier trades and do well on those, too, even though they may run against me at first. That is very bad, because it causes me to change my rules for risk management on "certain trades", as if certain trades are just so good they don't require risk management. The biggest demon to take me down is the one that says a price is ridiculous and could not possibly get more ridiculous therefore staying in the losing trade is the right thing to do, because surely people will regain their senses and the trade will do what it was supposed to do originally. I've been drawing up theoretical examples comparing two styles of trading: 1. Cutting losses quickly when a trade fails to do what the setup indicated it should do. 2. Averaging as the trade moves against you, because the setup is so strong that the price MUST eventually retrace some of that move. (Be sure to define "eventually" because as they say "the market can stay irrational longer than you can stay solvent".) Scenario 1: You short 1000 shares of stock at 20.00 on a fantastic setup, .20 cent stop. The trade moves against you and you're down $200. You see the stock move to an even better short entry price when it stalls at 20.50 and you put on 1000 shares with a .20 cent stop. The stock rallies once more and you're down another $200. The price moves within pennies of the next round number and pulls back a bit, and now the setup is really strong so you put on your full position of 2000 shares at 20.90, .20 cent stop. It's late in the day, the buyers are finally done and the price falls hard to 20.40. You take your $1000 profit, and end the day up $600 overall. Scenario 2: You short 500 shares of stock at 20.00 on a fantastic setup, no stop because you plan to build into a full 2000 share position if it moves in your favor or against you. The trade moves against you and you add 500 shares at 20.30. The stock moves to 20.50 and stalls, so you add the rest of your intended position (1000 more shares) at 20.50, giving you 2000 shares at an average price of 20.33. The stock suddenly rallies further moving within pennies of the next round number and pulls back a bit, and now the setup is stronger than ever. Do you violate your max position size for the trade and add more here? Let's try it both ways: a) You hold the existing 2000-share position and wait. End of day selloff to 20.40 gives you a net profit of $140. b) You add 1000 more shares at 20.90 for 3000 shares at an an average price of 20.52. End of day selloff to 20.40 gives you a net profit of $360. OK, this isn't so bad, all trades ended the day profitable, but the safest method of trading ends the day the most profitable. This is a win-win situation. Now let's assume the setup was not only strong intraday, but even stronger looking on the 30-day chart and the fact that the stock will surely retrace a good part of the move up within a few days convinces you to hold the winning position overnight to catch larger piece of the move. Next morning you check the stock and it's gapped up to 22.50 in pre-market trading on good news. Scenario 1: You have 2000 shares at 20.90, now an unrealized loss of $3200. Scenario 2: You have 3000 shares at an unrealized loss of $5940. Is there a down side to a strict risk management and re-entry strategy vs. an averaging strategy? I can't seem to find one.
You need to also decide how much risk vs reward to take for a trade. Does a certain trade have a higher win%? If so, and your plan is that you will say average twice into the trade at different price points, then that is fine. However, the market can be random at some times, so you don't want to keep adding to a losing position even one with a high win% since you may have even made a mistake on analyze the setup or the optimal price to get into the trade, for example you chased the move a little. Let's say I expect a normal trade can move 1 to 2 to 3 points, and I have a 1 point stop loss. However, on another trade I expect a possible 4 to 8 point movement, then maybe I have a looser stop loss and will add one more time to get a better average price for this trade. I currently discovered a good setup I like based on logic, but you could have some news event come out after you got in the trade that invalidates it, so you can not expect the market to come back which is now hope mode. The best thing you need to do is act like a machine once you take your high probability trade, don't change the stops and profit targets. It can take hours waiting for a good setup and hours for the trade to reach the stop or profit target. For longer term trades for example, I am waiting for FDA approval on some drug stocks, then I need to be in the trade for months and not get scared out based on some rumor or someone bashing the stock.
Just trying to add that overnight position can be unpredictable, it can gap up or down unexpectedly without taking into account of previous day performance
TraderNik, I have done this in the past but hated to miss out on so many trades that don't make it to your entry. Do you find that?
I know that there are common support/resistance points, moving average points, stochastic points, etc. that lead traders to place stops or limit orders around those price levels. If you join the crowd in doing the same thing, I believe you risk having your stop hit just before a reversal, or having your limit order missed by pennies. For example, say XYZ stock has been falling and is approaching a major support level of 25.00. You want to buy the stock around that price and then set a stop .50 cents below that price, because a breakdown of support would be bad sign. Scenario 1: You place a limit order for 25.00, the price drops to 25.15 and buyers all pile in, quickly driving the price above 26.00. You've missed the entry by pennies. Scenario 2: You place a limit order for 25.00, which is filled as the price drops to 24.95 and continues to fall. Your stop of 24.50 is triggered for a loss, but buyers pile in at 24.45, quickly driving the price above 26.00. You took a loss only to see the trade move nicely in your favor. This makes sense to me and does not seem like a big market conspiracy; it seems like natural round number support and resistance points being used by a large number of traders and so many will miss out as the volume picks up at those points. But I've always wanted to know what goes on behind the scenes when traders talk about "gunning stops" or "running stops". How, exactly is this done? Do market makers/specialists see a particularly large number of stop orders around a certain price level and do something specifically to drive the price to that level so they can buy or short a large number of shares and benefit from the reversal that will occur once those stop orders are filled and the buying/selling pressure is finally relieved, causing a reversal?
Just my two cents, I prefer to never average down / martingale / add risk when i am losing. I prefer the fixed fractional method of compounding money after each trade is complete. That does not mean I necessarily average up, but i think averaging up is sort of better than averaging down. Kinda like if you have a failing investment real estate property and a nuclear accident happens near your property, making it unusable. You don't double down on your investment by making renovations to the units to make it more attractive. Yeah Ok weird example, but i think you get the point. (On the other hand, if your investment is cash flowing SO HARD that you are getting richer, you will of course go out and buy some more rental properties or increase risk now that you have more.)
I only have one friend who is a trader. He buys on the pullbacks and averages down until the position turns if it goes against him. I've seen him buy 20 options, and end up with 100-200 as he averaged down. I've seen him down $30,000 on a position, only to have it evantually make $1000. I think he averages about $60,000+ yearly trading with very few losing positions and has been doing so for about 12 years. So if you have a feel for the market and enough $, you can go this route with success.