StockFetcher Forums · General Discussion · Article: Averaging Down is a Losing Proposition<< >>Post Follow-up
guru_trader
485 posts
msg #40560
Ignore guru_trader
1/21/2006 3:06:00 PM

Source: http://biz.yahoo.com/tm/060120/13812.html

TradingMarkets.com
Averaging Down is a Losing Proposition
Friday January 20, 9:27 am ET
By TradingMarkets Research

Many traders, especially those new to the markets, have a habit of "averaging in" to trades that aren't going their way. The following reasoning is used: If this trade was a good entry at my earlier price, then it must be an even better entry now! On top of that, the trader gets caught up in the idea of improving his "average entry price."

DaytradeTeam traders have seen this mistake all too often...

Unfortunately most traders learn the hard way that this logic simply does not hold up. This is a natural response that everyone has, which is exactly why it doesn't work in a market. The reasoning that "this trade was good then so at this price it must be even better" is based on the flawed assumption that the first entry price was a good one.

[Chart here: http://biz.yahoo.com/tm/060120/13812.html]

Pride tries to keep us from realizing that the very fact that the position is a loser right now is PROOF that the first entry was NOT a good entry (at least not yet). In fact, the stock or option has moved in the opposite direction the trader thought it was going to move, indicating that either the analysis/reasoning used to take the position in the first place was incorrect or at the very least the reasoning has been weakened by the market action since the position was established. This does NOT mean that the trade is no longer a good one just because you did not make your initial entry at the perfect moment (who does?) -- it just means that you probably shouldn't be willing to put more capital at risk now that it has started to prove you wrong.

The other part of the reasoning, that "this will improve my average entry" is simply a mathematical illusion.

By "averaging in", you don't just move your entry closer to the current price (the part Pride makes us focus on), you also double your losing position (the part we don't want to see). Instead of 1000 losing shares at 10.25 you now own 2000 losing shares at 10.00 -- BIG DEAL -- you are still down $500 because the stock price is still at $9.75 and now you own 1000 extra shares of a stock that is in a downtrend instead of the uptrend you predicted!

Don't get me wrong, it is not always a mistake to increase your position on a losing trade -- some circumstances (such as the stock sitting right at a very strong resistance or support level) warrant it. If you absolutely must add to a losing position, always do so with the conviction necessary to exit the ENTIRE position quickly should the trade move against you (through that critical support level you saw, etc.) from there.

On the flip side of the coin is the exact opposite reasoning and the exact opposite results over time. Adding to winning positions is a practice rarely done by even the most experienced traders, but one that can lead to increased profitability over time. This is exactly the strategy that our #1 ranked Day Trading System has used successfully since 2000. The next few times you hear pride telling you to "lock in your profits", double your position and set a stop at your new "average entry". After 5-10 of these trades you will be surprised at what a profitable (and a confidence building) method this can be.

Once again, traders who ignore pride and trade the opposite of emotion will reap extra profits and a much more pleasurable trading experience. DON'T MISUNDERSTAND ME -- you will not profit more every time you add to a winner and you won't lose every time you add to a loser -- I am talking about trading strategies to work OVER TIME -- anything can happen in the window of a few trades.

Andy Swan

Andy Swan created and co-founded DaytradeTeam five years ago on a principle of empowering individual stock and options traders with the techniques and analysis methods typically reserved for elite professionals. His expertise in technical analysis and commitment to educating members earned DaytradeTeam a top-ranking among advisory services for several years. Go to www.TradingMarkets.com to find out more about a free trial to Andy's live trading room.


nikoschopen
2,824 posts
msg #40563
Ignore nikoschopen
1/21/2006 4:28:09 PM

By definition, a daytrader is s/he who closes shop at the end of the session. Hence, technically speaking, taking home a loser doesn't apply. However, I see no reason why the concept of "averaging down" would not work when the market moves in your favor. For example, I took home a stock overnight thinking that it might gap up since it closed at the top the range. Lo and behold, the damn thing gapped alright, but down and not up! However, I noticed all three major averages trending up, and I started to sequentially average down my losing position. To make the story short, I closed out the position with a slight profit by averaging down, which otherwise would have costed me an arm and a leg (just one of each).


TheRumpledOne
6,358 posts
msg #40596
Ignore TheRumpledOne
1/22/2006 5:02:33 PM

Do you know how www.TradingMarkets.com calculates their Power Ratings?

We could do that with StockFetcher!




curmudgeon
103 posts
msg #48962
Ignore curmudgeon
1/5/2007 2:20:06 PM

TRO - I would be very interested to work towards figuring this filter out with you.


TheRumpledOne
6,358 posts
msg #48966
Ignore TheRumpledOne
1/5/2007 4:19:15 PM

All I need is their formula then I can code it.




corsino
259 posts
msg #48971
Ignore corsino
1/5/2007 5:51:28 PM

I don't think that you can say that averaging down is necessarily a losing proposition, any more than you can say that averaging up is necessarily a winning proposition.You can probably find just as many examples to "prove" either case. No stock goes down or up forever.Money can be made either way if done intelligently.


TheRumpledOne
6,358 posts
msg #48972
Ignore TheRumpledOne
1/5/2007 6:08:37 PM

Averaging down and exiting with a profit is "ego driven".

You are actually losing on one trade and winning on the other unless the price exceeds your original exit price.

If you exit early with a loss and reenter with twice as many shares, you make up lost ground quicker.

Don't be fooled by the "illusion" of the P/L column on an averaged down trade.





curmudgeon
103 posts
msg #48978
Ignore curmudgeon
1/5/2007 10:00:31 PM

TRO - I dont have the formula in hand. It looks like the lower a stock goes the higher the ranking goes. The problem I have with their system is I still have to filter out some junk and I dont know if the stock is actually in a persoanl bear market decline anyway. What if you you could base the decline against something like the comparative relative strength XXX/SPY of the stock and the ATR. That way low volty stuff with lower odds of a substantial upward movement would be filtered out.


StockFetcher Forums · General Discussion · Article: Averaging Down is a Losing Proposition<< >>Post Follow-up

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