I want to share a simple rule that has worked well for me over the years. I’ll explain the how and why, and then wrap up with some thoughts about when this rule might not be appropriate.
So, imagine you are in a position, and then, for whatever reason, you know it’s right. In fact, it’s so right that it’s time to add to the position, and so you do. Now, think about what happens if the trade turns out to not be right, or to not develop as you expected–what do you do? Here’s the rule: if you add to an existing position and it does not work out as expected, you must get out of more than you added. Simple rule, but effective.
To put numbers to the idea, say you are long 5,000 shares of a stock. As the trade moves in your favor, you get a signal to add to the trade (and that “signal” could cover many possibilities.) So, you add 2,000 shares. Somewhere down the road, the trade does not work out, and probably is under the price at which you added. Now, you know the right thing to do is to reduce the position size, and you must do so, but how much do you sell? Answer: more than 2,000, and probably more like 4,000 than 2,100. You now hold less than the original position size, and you’ve booked a loss on part of the position, but you’ve also reduced your risk on a trade that was not developing as you thought it might.
One of the classic trading mistakes is to have on a winning trade, add inappropriately, and have that trade become a losing trade. For some traders, being aggressive and pressing when they have a good trade can add to the bottom line, but there is a tradeoff: when you become more aggressive you do so by taking more risk. The psychological swing–going from aggressive to wrong–can be one of the most challenging experiences for a trader, and many mistakes happen in this heightened emotional space. The rule of exiting more than you added is a simple rule, but it protects you from yourself.
Now, no rule fits all styles of trading all the time. There could be styles of trading for which this is inappropriate, (for instance, when we add planning to scale in as the trade moves against the entry.) However, for “simple”, directional technical trading, this rule might be helpful in many cases. So much of the task of trading is just about avoiding errors and mistakes, and correct rules lead to good trading.