I'm sure most traders are familiar with this situation. You find a good setup, watch it for a while, then enter a trade, and it goes down right after you entered. Should you double down and add to your losing trade, or should you cut the loss and exit? That depends who you ask.
If you ask a momentum trader, the answer usually will be "admit you were wrong, cut the loss and get put". Doubling down on a losing trade is throwing good money after bad.
If you ask a value investor, the answer would be "add to a losing position". After all, if he liked the stock at $100, it is probably an even a better deal at $90.
However, we don't trade stocks. We trade options. Specifically, we do non-directional trading based on Implied Volatility. So our criteria is completely different.
Consider the NFLX calendar spread that we entered few weeks ago. Based on backtesting of previous cycle prices, we concluded that entering at 0.95 per spread would be a good entry point. The trade was based on volatility skew between the front and the back months leading to upcoming earnings.
Few days later, the market makers decided to re-price the options, and the spread was down to 0.85-0.90.
One of our members posted the following comment on the forum:
"This is what is called a "losing trade". The best thing to do , once you aware that it is no longer the trade you initially put on, is close out the trade. .80 -.85 cents will look wonderful when it is .65/.75. There is just no reason to tie up money on a trade with no potential ."
My response was:
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"Personally, I'm adding to my position. And I would suggest in any case not to panic. Long time members know exactly what I'm talking about."
A member responded:
"Adding to a losing position is a losing strategy. The reason why people get sucked into it, as with any other bad habit, is because, just like anything, it does work on a rare occasion , then you continue to do it, because you remember the handful of times it works, and now you have added a bad trading habit to your arsenal.
Protecting capital is way more important than possibly losing out on a losing trade turning around.
Just because you once added onto a losing position, and it worked that time, is a poor reason to incorporate it into your trading methods.
The only reason why this trade is different than adding onto other losing trades, that have the potential to REALLY hurt you, is that there is no way you will ever lose more than .20 cents from this point. But, that is not a valid reason to add onto a losing trade."
Here is the thing: those trades are different from buying a stock. A stock can go to zero, so adding to a losing position can be very risky. But taking advantage of temporary mispricing is NOT a losing strategy. In fact, we did it many times with great success.
We closed the trade for an average price of 1.20, 26.3% gain. Not bad for a "trade with no potential".
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