FOREIGN exchange markets have been notorious over the past year for their rapid fluctuations and numerous driving forces, which can make holding a position in a currency pair a particularly nail-biting experience for any trader, whatever their level.
But greater stability in the markets over recent months has seen a number of trends emerge in the currency markets, such as US dollar weakness and falls in sterling, while the yen and the Aussie dollar have both been steadily gaining strength.
This is not just good news for your cuticles, it can also be good for your profit and loss account. While one of the first lessons of any type of trading is to develop a plan and be disciplined enough to stick to it, there are some cases where currency traders can use the technique called averaging in, ie changing their position size throughout the life of the trade to maximise their profits and minimise their exposure to risk.
This technique of gradually building up positions or staggering an exit has two key benefits for traders. Firstly, by buying/selling at successively higher/lower prices – depending on whether you are long or short respectively – allows you to improve the average price of your position and increase your position size.
Secondly, you can build up or reduce your position in a currency pair depending on how confident you are in the trade – this is ideal for investors who are new to the currency markets and gaining experience. As your view begins to be realised, you can add to your position and maximise your profit potential. Equally, if you lose confidence in your trade, or if the market starts moving against you, you can scale back your exposure to reduce your risk.
Averaging in makes more sense in trades with medium- and long-term time frames where a reversal is anticipated. Short-term trades are usually purely speculative and you don’t want to compound your losses.
TRADE WITHIN A TRADE
However, that shouldn’t stop you from trading within a trade, where you briefly add to your position in a currency pair to take advantage of some economic data – for example an interest rate decision.
But remember, doubling your position doubles your exposure and your risk, which is why it is generally unadvisable to average into losing trades. You are also not taking advantage of the current direction of the market, increasing the opportunity cost of the strategy.
When a position starts to turn against you, then you would want to get out of, say, half of the position and reduce your exposure, says Philip Gillett at IG Index. “If it does fall further then I can buy it again at a cheaper rate or if it continues to go against me then I can get out entirely and I am not as badly off as I would have been,” he adds.
With currencies no longer wildly fluctuating, averaging in and out of positions is a good way to fine tune your trading strategy.