Averaging Down – Ineffective Trading Methodology
Averaging down can feel like a natural response to a trade going against you that you firmly believe will work. It's like getting a better deal on an already awesome trade opportunity.
But is averaging down profitable over the long-term? Also, can you average down when day trading?
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In this post, we will cover the basics of averaging down and why this approach is not the best method for managing your money when trading.
What is Averaging Down?
Averaging down is the process of adding to a position as it goes counter to your initial transaction. In theory, this makes sense because it will allow you to obtain the same asset at a lower price. Therefore, you can average down the entry price and in turn, increase the profits when you close out the position.
The major flaw in this strategy is that you have no clue which trades will rally in your favor and which will continue to slide lower.
Why Not Just Cut Your Losses?
If you are reading this article, odds are you have heard the adage of cutting your losers and letting your winners run. This sounds easy enough, but why is this so hard to do?
It is a fundamental part of human nature to hope. Once you have accepted a loss for what it is, then trading becomes one of the most straightforward business operations you could ever undertake.
The problem with so many of us is that we can not let go of the hope. Therefore, when we see a stock is no longer going in our favor, instead of taking the loss, we do the "smart" thing and add to the position.
Investors use phrases like averaging down to justify there reckless actions of not only holding onto a losing position but adding to them. Let's step back from the trading game for a second and let's put this another way.
Would You Average Down with any Other Business?
To simplify the concept of averaging down, let's say you owned a small housewares shop. You sell all types of products, but you recently added a new style of toaster that is going to change how people eat their breakfast.
You place the toaster in your front window with banners and ribbons, but in your mind, you think this isn't necessary because the toasters will sell themselves because you believe in the product so much. However, to your surprise, you were only able to sell one toaster in an entire week.
You look over your inventory sheet, and you realize that you have 499 toasters left to sell, so you begin to worry a little and a phone call to the supplier is in order.
Somehow Things Get Worse
The supplier empathizes with your concerns, so they offer you an additional 20% discount to improve your margins. This time you know that things will be better because you can average down on the price you paid for the toaster.
In your mind and heart, you know that the only reason the toaster is not selling is due to the price. So, you take the supplier up on their offer, and you purchase an additional 1,000 toasters because you would now have 2/3 of your inventory at the discounted rate.
Then to your surprise, there is no additional interest, and you are still unable to sell any toasters. What would you do at this point? Would you average down again?
Trading is just like any other business. So, why expose your trading account to this reckless behavior?
2008 Mortgage Crisis - Example of Averaging Down
For those of you that could remember the selloff in 2008, it was nothing short of brutal. The market fell off a cliff and just kept going.
As an investor, you may have decided to buy the Dow Jones as it was tanking. Well, this is what it would have looked like as you were making your buy orders.
As we all know, the market has rebounded to over 25 thousand over the past nine years. However, you are purely throwing a hail mary when you let you start to buy into a security when it's 50% below your first entry price.
Why You Should Only Average Down from a Position of Strength
This may sound a bit confusing on the first read, but when I mean by a position of strength means you are buying into dips of a strong trend.
Let me illustrate this through the charts, so you can get a better feel for what I am saying.
Let me ask you which chart has a stock you would want to average down?
You are probably thinking, well you can't average down in the first one because it's at highs and showing real strength.
Well, that's precisely what we want to see.
You just need to go to a lower time frame, like 5 minutes for example to find an opportunity where you can average down in the stock.
Remember, this stock was at multi-month highs on a daily chart. So, buying into this stock would be buying right as it is breaking out on an intraday and daily basis.
This is how you buy from a position of strength.
Let me be very clear here as I wrap up this section of the article, I do not believe in averaging down, but if you are going to do it, you have to buy into a stock that is trending strongly.
Let me be very clear here as I wrap up this section of the article, I do not believe in averaging down, but if you are going to do it, you have to buy into a stock that is trending strongly. Click to tweet
How Should You Close Your Trades
There are two choices you have when deciding how to close out your trades. Please review each approach in detail and think back to your trades to see which one will work best for you.
Close the Position Out in Pieces
If you have averaged down, you may think it makes sense to close the position out in pieces. For example, if you had four buys into a falling stock, you would have the same four sells to exit the trade.
Now, this is where it gets a bit tricky.
If you are up on the position and you want to scale out as things go in your favor, this makes total sense. You are never going to go broke taking money out of the market as things go your way.In the above chart example, you can see three entries and three sells. This scenario would be the best you can hope for with this approach.
Averaging down would have allowed you to gain a better average share price, while you are then later able to scale out of the position at much higher prices.Two Things Required to Close Out in PiecesThere are two pieces to this puzzle you need in your favor. One as you average down, you need the stock to hold up and not continue lower.Secondly, the rally not only turns a profit for you but rallies strongly enough that you can sell out in equal pieces.As you think through these two requirements, it's easy to see that the likelihood of all these things playing out is unlikely.
This is also even more challenging of a concept when you factor in day trading, as the morning high set within the first hour of trading is often the high for the entire day.
Conversely, scroll back up again to see the first averaging down example where the stock kept trending lower. In this event, how do you scale out of a losing position?
This is where paralysis could set in and as stated earlier, you now take a massive loss as you are carrying a large position after averaging down and you are completely vulnerable.
Close Entire Position
If you are closing your entire position, you are doing so for one of two reasons: (1) you have hit your target price or (2) you are getting crushed, and your stop loss was triggered.
Hit Your Target Price
As of late, meaning the last three months or so, I have been holding my entire position until my profit target is reached. I can do this because I am trading high float stocks that move in a reasonable fashion. Therefore, when I am right, and things are going my way, my stocks will slowly grind their way up to my target.
I can sit in the slow and steady stocks until my target is reached. However, with the low float flyers, I suck at it. They always shake me out on one of those big red candles.
The benefits of holding your entire position until you reach your target are you reap all the profits at the highest price. The downside is you are completely exposed until your goal is reached.
Stop Loss Exit
Now this one will hurt the most.
Let's say you have averaged down in the trade. Depending on how you averaged down will determine how much pain you are feeling at this point.
If you have a set amount you use on every trade and you scale in, then while you will take a loss it is still manageable.
Now, if you use a set amount per trade, but have gone beyond your standard per trade amount and have doubled or tripled your exposure when averaging down - you are in trouble.
Regardless of the amount of how seething the pain due to the loss, closing out the position at your predetermined stop is the right decision.
I do not average down, and from reading this post, I'm hopeful I gave a clear reason why. Ultimately, this is your decision. I would recommend that if you are going to average down, you track your results over a minimum of 20 trades or more. See if averaging down has helped improve your bottom line.
If you do not have an account, you can use our tradingsim platform to test out your theories to see if they will work in the real market.