“I don’t think you can consistently be a winning trader if you’re banking on being right more than 50% of the time. You have to figure out how to make money being right only 20 to 30% of the time.” – Bill Lipschutz
Most aspiring traders (and also some experienced traders for that matter) have difficulty being wrong. And this warps their mindset, so instead of searching for a consistent approach that leads to an upward sloping equity curve, these traders tend to search for an approach that makes consistent wins. However, there’s a trade-off to everything and it’s virtually impossible to have a 90% win rate and also large profits. Usually just the opposite is true: the higher the win rate, the lower the risk:reward ratio of the trades.
So our mindset needs to shift. Instead of maximizing the number of winners, we need to maximize the size of our winners. Sometimes this simply means holding onto a trade, and let it run. But sometimes conditions are ripe for “pressing the trade” or compounding into the trade, adding additional positions as the trade moves in your favour.
For example, Crude Oil has been recently pushing lower on poor EIA and API data. When some emerging fundamental data influences price, it can exacerbate volatility in the direction of the trend. That is when compounding makes most sense. Not when the market is moving along quietly.
Crude Oil Daily Chart with 1 evident resistance and 2 evident supports highlighted.
Crude Oil 1H chart – attempt compounding when something is influencing price, and the lower time frames are moving in the direction of the larger time frames.
Press the trade, don’t press your luck
Evidently, compounding means building a total position through multiple entries. However, having larger positions in the market increases not only your potential reward but also your risk. So we need to identify a way to press the trade, without pressing your luck.
Here are the ingredients to do this:
– each entry needs to be qualified on it’s own terms. Whatever entry strategy you use, those conditions cannot be bent or violated, especially when compounding. What we don’t want is to be compounding into a move that’s turning around. We don’t want to be compounding “just because” the market is moving.
Crude Oil 1H chart – we don’t know when price will start to move aggressively through the gears. So each initial entry needs to make sense on it’s own.
– only add additional positions when the stop loss on the initial position can be trailed, reducing risk on the initial entry. This means that we don’t want to be adding to a losing position. We add only if the position moves in our favour, allowing us to trail our stops and protect the initial entry.
Crude Oil 1H chart – additional positions are entered only when the market is moving in our favour.
– subsequent position sizes should be at the most as big as the previous position, but to be more conservative, they can also be marginally smaller. This is a logical way to ensure the pyramid that you build has a “wider base” and that each position added is a marginal increase. Remember, trends eventually end and we don’t want to be top-heavy right at the turn (which we will never know in advance anyhow).
– be sure to have a strong fundamental driver pushing prices along, because pressing trades anywhere, anytime, is simply bad risk management. Wait for something to influence price. Make sure you have volatility and trend on your side.
- tilt the odds in your favour by looking to compound on days that follow strong closes. The market closes strongly in the direction of the trend, and you’re ready to add another position since the trend is evidently very strong.
Crude Oil 1H chart – when you have a “runner” on, keep an eye on the close. Is it closing strongly in your favour, or is it reversing? This will give you clues as to what to expect the next day. It can also help you manage your trades.
Take Your Cue From The Bigger Picture
Strong trends require real money participation. And real money accounts (pension funds, mutual funds, large asset managers) are not interested in day to day wiggles of the market. So it’s only when price breaks strongly above a prior daily resistance (or below a daily support), that we can start to use the magnifying glass to start building our pyramid.
EurGbp Daily Chart
So now, once price is evidently in motion, we can simply wait until lower time-frame pullback cycles end, to get value entries into the larger move.
EurGbp 4H Chart
Compounding Risk Management
- diversify: if all your eggs are in the compounded trade, then your risk is concentrated. Instead, by remembering to diversify and still take trades in other currencies that fit your setups, your overall risk will remain at lower levels.
- stick to very strict risk limits: if you have 2.5% in one trade, 2.5% in another trade and a few other trades on, your total portfolio heat might very well be around 10%! Of course that may be acceptable for some profiles but generally speaking, that amount of risk is quite high. By all means, take the opportunities the market offers but if you have capital locked up in a compounded trade, it might be better to reduce the position sizes of other trades.
- be consistent with your position sizes: if your initial entry is 1 lot (100K) and your second entry is 5 lots (500K) then you are not building your pyramid correctly. The “base” isn’t the heavy part. Your add-in is heavier than the base. What this means is that even a small reversal can undo all the previous good work.
- Test: Experiment compounding with minimum size as it can be psychologically challenging as you combine two elements which each require practice:
- sitting on an existing trade, resisting the temptation to take profits early
- adding to the trade at “worse” levels, further along the price ladder. As traders we all know that trends, at a certain point, end. So we don’t want to be pyramiding into an evident and extended trend that has been going on for a while. We want to be pyramiding into a fresh trend, limiting our trend risk.
Over to You
Now you have the key elements to press a trade, without pressing your luck. Now it’s your turn to size up a potential situation. We have our strong driver: the Bank of Japan disappointed market expectations last week. We have closed strongly negative on the day and on the week.
A potential compounding candidate in the making?
About the Author
Justin Paolini is a Forex trader and member of the team at www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.