In my previous post entitled “Gambler’s Fallacy” I mentioned that you should not radically alter your position size (or trading frequency) based on the outcome of the last handful of trades. But when is it appropriate to adjust your position size?

Recall that the Gambler’s Fallacy occurs based on emotions, whether positive or negative. If your last few trades have been winners, and you’re newer to trading, this can lead to a sense of invulnerability, which can lead you to double (or triple) your normal size, and in doing so, you expose yourself to heightened emotional stress, and if the trade turns out to be a loser, you may hold on longer or behave differently, creating a larger than expected loss.

The key to creating the Gambler’s Fallacy is your faulty assumptions based on the most recent outcomes, rather than having a specific plan to change trading frequency or position sizing.

When might it be appropriate to change?

That depends on you and your selected strategy which you have predetermined either through experience or research.

Typically, a trader should change tactics whenever he or she perceives that the broad market, or the trading environment has changed. The market alternates between bull and bear, range and expansion, dull and volatile, fast and slow. You should have predetermined rules for analyzing the quality (or condition) of the market you’re trading so you can make clear distinctions and try to set up a framework of the current conditions and what may be coming next – and thus adjust your strategy.

In a raging bull market, increase your position size to the long (buy) side, because odds favor higher prices and positive resolution of trade set-ups (or stock selection). “A rising tide lifts all boats,” and you also want to “make hay while the sun still shines.” You may either choose to decrease trading activity because you want to hold positions longer, instead of trading in and out of them daily.

During a dull, flat, lifeless consolidation phase, you may want to increase your trading frequency on a reduced position size to take advantage of rangebound market swings (or you may wish to decrease your frequency and take a break from trading during this difficult period).

Also, your particular strategy will likely experience changes in the edge or expectancy during different conditions. As I’ve mentioned previously, the classic “Gap Fade” strategy performed wonderfully in January 2008, but decreased edge in February. Trader Eyal in a recent post also mentioned this phenomenon and described it well (including the shock that accompanies it) in his post “The Anatomy of Re-learning How to Trade.”

It is best to decrease trading size when your strategy shifts out of favor (or experiences reduced edge) in the Market. Educator Bo Yoder refers to this as the “Pay-out, Pay-back” cycle and notes that a major component of long-term success as a trader is knowing when your specific strategy is coming into a ‘pay-out’ cycle where it is aligned with the market (in which you increase trading frequency and/or size) or a ‘pay-back’ cycle, where your strategy has fallen temporarily out of favor, and you should decrease size and frequency or maybe take a break until you are sure (or assume) that your strategy has once again come back into favor.

Nevertheless, professional traders do increase or decrease both position size and trading frequency, but they do so based on a specific set of rules or variables that they identify, and they do so based on rules, rather than emotions. They certainly do not stress because their last handful of trades have been losers, or double-up because they have experienced a few wins.

Professionals deliberately adjust based on factors far beyond their emotions, while newer traders adjust almost exclusively based on their emotions. This is one of the key differences between creating the Gambler’s Fallacy or trading in line with market analysis according to a predetermined plan.

(Thanks to Tyro Trader for the inspiration for this post)