“I don’t think you can consistently be a winning trader if you’re banking on being right more than 50% of the time. You have to figure out how to make money being right only 20 to 30% of the time.” – Bill Lipschutz
Most aspiring traders (and also some experienced traders for that matter) have difficulty being wrong. And this warps their mindset, so instead of searching for a consistent approach that leads to an upward sloping equity curve, these traders tend to search for an approach that makes consistent wins. However, there’s a trade-off to everything and it’s virtually impossible to have a 90% win rate and also large profits. Usually just the opposite is true: the higher the win rate, the lower the risk:reward ratio of the trades.
So our mindset needs to shift. Instead of maximizing the number of winners, we need to maximize the size of our winners. Sometimes this simply means holding onto a trade, and let it run. But sometimes conditions are ripe for “pressing the trade” or compounding into the trade, adding additional positions as the trade moves in your favour.
For example, Crude Oil has been recently pushing lower on poor EIA and API data. When some emerging fundamental data hits the market, it can push prices further along the path of least resistance. That is when compounding makes most sense. Not when the market is moving along quietly.
Crude Oil Daily Chart with 1 evident resistance and 2 evident supports highlighted.
Crude Oil 1H chart – attempt compounding when something is influencing price, and the lower time frames are moving in the direction of the larger time frames.
Press the trade, don’t press your luck
Evidently, compounding means building a total position through multiple entries. However, having larger positions in the market increases not only your potential reward but also your risk. So we need to identify a way to press the trade, without pressing your luck.
Here are the ingredients to do this:
– evalaute each entry separately. Whatever entry strategy you use, keep it consistent, especially when looking to press your trades. We don’t want to be compounding “just because” the market is moving.
Crude Oil 1H chart – we don’t know when price will start to move aggressively through the gears. So each initial entry needs to make sense on it’s own.
– only add additional positions when price moves in your favour. We don’t want to add to a losing trade, throwing good money after bad. That would allow us to trail our stops and protect the initial entry.
Crude Oil 1H chart – additional positions are entered only when the market is moving in our favour.
– subsequent position sizes should be smaller than the previous. This is a logical way to ensure the pyramid that you build has a “wider base” and that each position added is a marginal increase.
– be sure to have a strong fundamental driver pushing prices along. Make sure you have volatility and trend on your side.
Crude Oil 1H chart – when you have a “runner” on, keep an eye on the close. Is it closing strongly in your favour, or is it reversing? This will give you clues as to what to expect the next day. It can also help you manage your trades.
Take Your Cue From The Bigger Picture
Strong trends require real money participation. And real money accounts (pension funds, mutual funds, large asset managers) are not interested in short-term moves. So it’s only when price breaks strongly above a prior daily resistance (or below a daily support), that we can start to use the magnifying glass to start building our pyramid.
EurGbp Daily Chart
So now, once price is evidently in motion, we can simply wait until lower time-frame retracements end, to get value entries into the larger move.
EurGbp 4H Chart
Compounding Risk Management
- diversify: pressing 1 trade can lead to a decent risk:reward, but do not overlook other high quality situations elsewhere. In other words, don’t put all your eggs in 1 basket.
- control your exposure: take the opportunities the market offers but if you have risk capital locked up in a compounded trade, it might be better to reduce the position sizes of other trades.
- build a “base-heavy” pyramid: if your initial entry is 1 lot (100K) and your second entry is 5 lots (500K) then you are not building your pyramid correctly. The “base” isn’t the heavy part.
- Test: experiment compounding with minimum size as it can be psychologically challenging to sit on a more volatile P&L.
Over to You
Now you have the key elements to press a trade, without pressing your luck. Now it’s your turn to size up a potential situation. We have our strong driver: the Bank of Japan disappointed market expectations last week. We have closed strongly negative on the day and on the week.
A potential compounding candidate in the making?
About the Author
Justin Paolini is a Forex trader and member of the team at 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.