“Only losers add to losers.” – Somebody

You have probably heard something like the statement above. It is one of those things that the advisor thinks is a timeless pearl of wisdom. Twitter is full of gurus who spout this type of garbage. These people are popular. But popularity is no guarantee of correctness. My first job was as a high-school janitor and my boss would regularly say things like, “when you are thirsty, there is nothing like a drink.” Murray would have had 100,000 twitter followers in a week.

“Losers add to losers” isn’t even trivially correct like saying that a drink helps with thirst. It is, at best, a gross simplification and, more generally, is just wrong.

The way you scale in and out of a position is dependent on why you did the trade in the first place.

Let’s say you are a trend follower, and you got long in a rising market. Your prediction (And let’s be clear for a moment, despite what they say, trend followers do predict. Their prediction is “because the market is going up, it will continue to go up.” Whenever we do a trade we are implicitly predicting that the market will move in the corresponding direction.) is that the market will continue to rally. But then imagine that after your trade, the market starts to drop and then drop some more. At this point, it would be wrong to add to your position. This is because you are wrong. Your prediction was wrong. When you are wrong, you exit and wait for another trade. Trend followers should not add to losers.

But now imagine you are trading something that you expect to reverse its recent move. Maybe it is a spread that has deviated from its usual level, and you are betting on reversion. Let’s assume it is trading $90, and you think it is worth $100 so you buy it. You think you have $10 of edge. But now the spread drops to $85. It would be a mistake to get out because now you have more edge. You have lost money, but you haven’t been proven wrong (Of course if the spread keeps dropping you may have to re-evaluate your idea of fair value and hence your forecast, but that is a different story).

You shouldn’t exit a trade when you lose money. You should exit when you are wrong. Sometimes being wrong and losing money are correlated and sometimes not. If you understand your broad strategy, you will understand this distinction and know what applies in your case.

There are two lessons here:

• A scaling strategy is entirely dependent on why you are in a trade.
• Don’t look down on people just because they aren’t smart. Murray wasn’t the sharpest tool in the box, but he never claimed to be and he sure knew how to use the tools in his box. He taught me how to rivet and remove a seized nut, but I wouldn’t go to him for trading advice. I hope he is doing OK.

Disclaimer

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