ForexSpirit

If cost averaging is such an important part of my forex trading strategy then why do I bother to ever close a trade out for a loss? Why not just keep cost averaging until all my open positions come back into profit and then close them all out?

If you’ve harboured such questions then you might find a current thread on the Oanda FXMessage forum rather interesting. If you’d rather not wade through the, at last count, twenty pages of posts then I’ll briefly describe the trading method being discussed and the interesting questions it throws up.

Original version of averaging down strategy
The original poster, fxnighttrader, only trades in the direction on a currency pair that earns daily interest. Once a day he performs a few simple steps:

1/ If no trades are currently open, then place a market order with a size of 1% of available balance
2/ If at least one trade is already active, then check the following two possibilities:
a/ If the result of all open positions is in profit (i.e. if current price is above the average price of all open positions) then close out all positions. Take your profit. Then perform step 1 again, opening a new market order with a size of 1% of the new, higher, available balance
b/ If current price is 100 pips or more away from the average price of all open positions then place a new market order that is equivalent to 1% of available balance.

A pretty simple trading simple, where you are continually averaging down as long as price keeps moving against your one trading direction. You will earn daily interest on all open positions as they linger in the red, and as long as you can hang on until price comes back to cross above your average open price you are okay.

An interesting point to note about this original version of the system is that, as price continually moves away and new positions are entered each time price is more than 100 pips away from the average open price, the size of each new order placed will be less and less. This is due to the fact that as price moves against the open positions your available balance will be getting less and less. Therefore, 1% of this available balance will also be getting less and less.

Let’s look at what would happen if you use a fixed lot size instead of 1% of available balance. If you use a fixed lot size for each entry then on average you will need price to retrace 50% of any move against you before your positions will re-enter the land of profitability and you can close them out.

Fixed lot size scenario
A quick example should clarify why this is:

I start trading this system on USD-CHF and I place a long at 1.25 using a fixed lot size of $1k. Over the next four days price drops and I end up placing entries at 1.24, 1.23, 1.22 and 1.21. All five of my entries are a mini-lot in size ($1k). How far would price have to go back up before I would be able to close out all five trades for some overall profit? Price has dropped 400 pips in total, from 1.25 down to 1.21. My average open price in this example is at 1.23. This means that if price recovers and goes back above 1.23 I can close out all my positions at once to realise some profit. 1.23 is 200 pips above 1.21. 200 pips is half of the 400 pips fall in price. Thus, anything above a 50% move back up using a fixed lot size for each entry will result in some profit.

What happens if you use the original trading strategy’s approach of using a decreasing lot size for each new entry? All that will happen is that price will have to retrace more than 50% of the move going against you before you will have a chance to close out in profit. The only advantage to using smaller lot sizes on each subsequent trade is that you are using up your margin less quickly.

You should also now be able to quickly see that if you actually increased your lot size each day that you would require a move back up of less than 50% to be able to close out in profit. You end up using your margin more quickly as the lot sizes increase with each new entry, but you don’t have to wait around as long for price to get back above your average open price.

The big pitfall
While fxnighttrader’s original version of this trading strategy makes great use of the benefit that cost averaging can bring to a trader, he does nothing to limit the downsides that need to be contended with.

What happens if price never gets back above the average open price? You end up continuing to add new positions day by day as price continually hits being 100 pips or more away from your average open price. Before you know it you end up receiving a margin call from your broker.

This is why when I apply cost averaging as part of my trading strategy, as built around the Bird Watching in Lion Country 4×1 methodology, that I am not afraid to close out positions that are going against me. If the current short- or medium-term trend is against my long term directional bias and I have open trades that are in the red, and the current outlook is for more movement against me, I will close out some or all of those losing positions rather than see them jeopardise my whole trading account. You must always look to be able to live and trade another day. Any scenario that threatens the preservation of your trading capital you must be critically evaluated. You must have plans in place on how to tackle these potentially doomsday scenarios, as they are probably more likely to happen that you would ever believe.