I was recently asked a question by a reader who is still learning how to trade. He entered a short NZDUSD at 0.6540 on September 9th, and a short AUDUSD at 0.71711 on September 17th and wrote me on September 20th asking for help and what to do with the losing positions.
Proper money management techniques should ensure that these situations never happen. But the truth is that even experienced traders sometimes get stuck in a toxic position because of poor judgement, getting married to a certain trade idea, or some technical error.
What follows is the way I confront losing positions. The core idea is to reduce exposure at favourable areas when possible. But other times, you just have to cut the position and take the hit. Let’s see how it’s done, in practice.
Inefficient Ways to Cope with Losing Positions
Let’s be honest. Trading is all about correct timing. That’s what differentiates buy & hold investing or longer-term asset allocation from trading – be it short-term, medium-term or longer-term. The core concept of trading is that your timing abilities are stronger than average and offer you an edge. It follows that if your timing is off, you get out of the trade and re-assess.
But most retail traders unfortunately cannot seem to do this. They hold onto losing positions for ages, as the chart below illustrates.
Source: Oanda MT4 Open Order Indicator
Without a proper money management structure, and without the discipline to stick to hard stop losses and admit being wrong, retail traders typically either
- cut the whole position when their (psychological) pain is just too big;
- average down (martingale) hoping for the best (but usually obtaining the worst).
However, there is a better way to handle these situations. Once you realize that your timing is wrong, you need to “lighten your burden” by trading out of the losing position. There is no room for wishful thinking. Admit that your timing was off (and there’s no shame in this, or negative emotions to be felt – really!) and try to preserve as much capital as possible.
Case in Point: AUDUSD and NZDUSD
The key is to know what kind of adverse behaviour would negate your timing efforts, and then start to lighten your burden. Do NOT add to the position. Instead, we will be looking at how to reduce exposure in order to gain more flexibility and also reduce the stress of carrying a fully loaded losing position. Then, with a more balanced mindset, you can do the (useful) hard work and try to scale out of the losing position.
The key is to use this flexibility wisely, and use intraday volatility to get a better average price.
So starting with AUDUSD, it’s quite evident that any move above 0.7230 essentially negates the trader’s timing for this trade. Without a hard stop at 7230, here’s how the trader could have approached the losing trade.
- Once above the key 0.7230 level, the timing no longer makes sense. Now it’s a case of limiting exposure until the short-term trend shows a (temporary=) change of direction, allowing us to use the capital we have freed up from the original trade to take on short-term opportunities and attempt to get a better average price.
- The key is to NEVER add to the total exposure, but try and obtain some profit from shorter-term trades which then enhances the average cost of your position.
This is possible even with a stop loss on the original position, if you have the skill or technique (and time) to attempt this kind of thing.
Remember the overarching objective here: MINIMIZE LOSSES. It’s not a case of breaking even, or even hoping to turn the trade around. We’re trying to save as much capital as possible with these techniques – that’s it!
When to Simply Cut Losses
Sometimes the market doesn’t allow us to do much at all. Evident cases are Brexit, Elections, sudden geopolitical events…basically anything that catches traders by surprize where the ramifications of the event aren’t immediately clear. Remember that uncertainty is what traders hate – so if something big hits the tape, the best solution is usually to cut your losses as soon as possible.
Bottom Line
Good traders use proper money management techniques in order to ensure that no single adverse trade can compromise their account. But in the event of a technical error, if you ever find yourself in a losing trade as described above, maintain your composure and limit your loss as much as possible.
About the Author
Justin is a Forex trader and Coach. He is co-owner of 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.