47 R U L E # 8
Never Add
attachment is now a more internal conflict inside the trader and shows a dramatic form of inflexibility.
In this case, a trader is unwilling to see objectively, and the cash loss is ignored while at the same time risk exposure is willingly increased. All other common-sense concerns that at any other time a trader would agree were in the best interest of his account are completely discarded.
The trader is actively participating in his own demise. Somewhere inside the trader there is a conflict, and that conflict has nothing to do with mar- ket price action or the net order flow. It has to do with the trader’s own unwillingness to protect the account, his need to be right, his hope that the market will come back, or any other justification process he might use for holding on to a losing trade in the first place. But instead of sim- ply holding a loser past a certain point, in this case the trader actively in- creases his risk.
If we stop and use a clear head when we trade, what benefit could we receive by willingly increasing our risk and our cash loss? There is no ben- efit whatsoever as far as our long-term trading success is concerned. Why then do some traders add to losing positions?
The reasoning behind “Never add to a loser” is very simple: Don’t throw good money after bad. The only way you or any trader could be in the position of adding to a losing position is if there was a failure to define the risk before the trade was done in the first place. Rather than accept a reasonable loss and learn the lesson that loss has to teach you the trader, the trader now makes a conscious and deliberate act based not on the fact of the net order flow but on the trader’s own emotional need for some- thing. That need may be a need to get back a loss, a need to fight with the market, a need for the market to pay a profit, a need to make a car pay- ment, or any number of little ways of saying the same thing. By adding to a loser, the trader is complicating the process of cutting a loss, thereby mak- ing his situation more difficult, but this act is based on something the mar- ket has no knowledge of to begin with: the trader’s own emotional need.
Remember, the market moves only because of the net order flow im- balance. Once you have executed and are now in a position, you are no longer in control of the net result to your equity. If you are not on the cor- rect side of the net order-flow as far as your chosen position is concerned, your account will accrue a cash debit until either you liquidate or the net order flow turns in your favor. If the net order-flow never turns in your fa- vor it is possible you could run out of margin funds before the price action stabilizes. By doing anything other than liquidating, you are increasing the risk that you will suffer ruin. Adding to a losing position is actually pyra- miding your loss! As an intelligent individual, how ridiculous does this sound to you? What trader would willingly put himself in the poorhouse at a geometrically faster rate?
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As a serious trader looking to master your game, you cannot afford to allow emotional or perceived psychological needs to influence your willingness to protect yourself. The reason you must never add to a loser under any circumstances is because the probability of being on the correct side of the order flow has already become evident due to the open-trade loss you are already holding. You are on the losing side to begin with; you haven’t seen it right, and that factalone, in and of it- self says “liquidate”—nothing else. Failure to liquidate means a bigger loss. Adding to the loser means an even biggerloss. How is that in your best interest?
Ask yourself exactly why you feel the desire to add to an existing loss.
If you take a step back and think it through, the reason will most likely be some form of emotional attachment to the trade results and some form of unwillingness to do the right thing. Adding to a loser is a symptom of a bigger problem the trader has: no real control over his feelings or emo- tions. A trader in that position is an accident waiting to happen.
Some traders make the mistake of defining a losing trade as a function of cash debit. By that I mean, an entry execution is followed by a liquida- tion execution and the two prices marked into the trading account yield a net negative dollar amount. I think it is far more beneficial for you to rede- fine the concept of a loss to include more focus on the issue of personal discipline.
If you find yourself executing into a market for some reason and, on further evaluation of your actions, you come to the conclusion that you are doing the wrong thing for you personally, then you need to liquidate to exit the market immediately. If you have broken a trading rule, if you have done a trade because of something you normally wouldn’t trust as an indi- cator, if you have emotionally wanted a profit, or whatever other misstep you may have made, you are most likely taking more risk than you other- wise would have. Ruthlessly liquidating to protect yourself is your best option, even if the trade has an open-trade profit at that point. A losing trade can be any trade done for any reason if your personal discipline has been broken in order to make that trade.
Once you redefine a losing trade from the standpoint of your personal discipline and not as a change in your cash balance, you are in a position to learn what you need to learn from your first loss—how to effectively participate on the right side. The issue of adding to a loser is never in question because you aren’t trading from a financial focus to begin with.
You are trading from the focus of discipline to do the proper thing all the time. You will not be tempted to add to your loser because you will have cut the loss by liquidating. You can always get back in, so there is no need to hold something that isn’t working and certainly no need to make mat- ters worse by adding to something that isn’t working.
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Fundamentally, making this rule work means admitting to yourself that you need something to control your emotional bias as it creates your urge to action. You need to confront the possibility that you personally have a “something” somewhere in your thinking and recognize that that particular little something has nothing to do with successful trading. The next time that particular little something shows up for trading, you will have already decided that you are not going to break your discipline to- day. The urge to add to a loser is a signal to liquidate because something is not right with me today. If something is not right with you, the trader, that has nothing to do with market structure or where the net order flow is. If you aren’t seeing it correctly today, that is clearly shown by an open- trade loss to begin with. At that point you liquidate.
Making Rule #7 work will lead to never breaking Rule #8. The only dif- ference between the two is the trader’s depth of attachment to the trade.
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51 R U L E # 9