Addicted to Average Down?

And this is why I DETEST leverage... Before, during and now one of my main interests in the market has been financial history since the 1800's. And it is amazing on how many times leverage has been a cause of a collapse.

 

I was interested in this statistic as well, and as it turns out, it does not matter. Percentage wise the stocks return the same amount (approximately). Absolute dollar amounts of course the amounts are different. However, I have lots and lots of positions and hence sometimes I end up with many smaller with some bigger.

But I do position risk management. Here is a real example for me. X

My average in point is 24.12, and when it was down it represented about 2,000 USD of position size. Doing the math I remember having about 90 shares of X. As X increased to say let's say its 60 and change that would have a value of 5,400 USD approximately. That size is too big for my risk.

Thus what I do is ensure that my positions don't get larger than around 3K, maybe 3.5K ideally 2.5K. This means I take profit as the stock goes up.

While having 5,400 USD in my account would be nice the problem is that I introduce event risk and portfolio risk. I learned early on you don't want a single stock moving your portfolio. Right now I am down to 20 shares or so of US steel and if Monday is a down day I will be completely out of the position.

The only reason I can do this strategy is due to IB... With any other broker I would need a seven digit account.

 

Thanks. Good explanation ... makes alot of sense.

 

Quote from NoDoji:

"That's exactly why I no longer use the strategy, because psychologically I just can't bring myself to add to winners! Is that crazy?"

I am with pension admin on this one, for all but a very select few, adding to loser is a poor strategy and indicative of psychological issues. You and christianhgross both said you can’t add to winners but you will add to losers. Let me explain why this is IMHO.

It is mostly psychological. There is also a lack of confidence in your system whatever it is. As someone else suggested, you add to a loser so you don’t have to admit you were wrong. You are trying to save face and cannot admit to yourself your timing was poor. You can’t stand the pain of admitting you were wrong so you average down and it will work most of the time if you have a large account. This is negative reinforcement at its worst. If it keeps going against you, you keep adding to it until you run out of money or the pain gets so bad you have to get out costing you much more money than if you took the first loss and just got out. The saying that your first loss is your best loss rings true. If you mistimed your trade, admit it, get out and reenter. You risk is much less and your stress level will go down. We aren’t risk averse as traders, we are risk managers with trades (or should be). I don’t care about being right all the time, I just want to take the least risk for the maximum possible gain. No more and no less. To continue to average down is to set yourself up for failure eventually. It is inevitable. You are training yourself a bad trade can be saved every time. Sooner or later, you will get stubborn and it will cost you all your money IMHO.

On to the winning side. You don’t add to winners because you are already “right” on your trade because you are showing a bit of profit already. You don’t have the pain of having to prove you were right to yourself on the trade because of this profit, the exact opposite of why you add to a loser. Buy adding to a position that is a winner; you believe you are massively increasing your risk because you already know you are “right” because you have a profit, no matter how small so you just won’t do it even if it is in your best interest and will maximize gains (most of the time). You won’t risk the hit to your need to be right (i.e. ego) instead of doing what is in your best financial interest.

A wise man once said the markets are set up in such as way as to fool most of the participants most of the time. My point is your hard wired psychology is set up to get you to do what is not in your best interest (in this situation). It is your job as a trader to figure out which of these hard wired traits are those to override. There is the rub. Most never do and many never even figure out how much they are really fighting with themselves (and losing) and aren’t even aware of these issues at all. Talk about stacking the deck further against yourself.

Just my opinion. Best of luck to all

BM

 

Thank-you for your long response, but I hate to say it, I don't think you were following any of the responses.

In essence what you are saying is that I average down because I need to be right and hence my account being deep enough allows me to be right all the time. This re-enforces bad behavior and will blow up.

You have this partially right. You are right that I have a need to be right. But if you were to read my blog at http://www.investorgeeks.com, or http://www.happyasahippo.com and look at my predictions for the year or my blog entries I am usually right. I keep a blog to keep me honest.

So while you have me pinned on the right bit, you have me completely wrong on the investing bit and how my "ego" makes me invest.

You are implying that I will average down and try to be right. In fact that is not what I do. It might appear to be that, but its not that from a psychological point of view.

I went back in history and looked at why people blow up. It appeared to me that that blowing up is not dependent on the style of investing. That means your approach of adding to winners and cutting losers will be just as likely to blow up as mine. Some might like to debate that certain styles are faster to blow up than others. But those are details since any style will still blow up.

Now comes the question, why do we blow up? Answer because we run out of money. That sounds kind of duh, but it is actually quite interesting. Because one can ask, if you did not run out of money would you have blown up?

The real question is if the original actors were right and had they enough liquidity would they have made their money? Answer is again an interestingly yes. Had they had the money then eventually they would have been right. LTCM is a very simple example since it has been mentioned. Had LTCM had enough money they would have eventually been right. About a year or so after their demise the market went back to normal. For the current blow up we will see that holding the CDO's to maturity will incurr losses a bit larger than modeled. In other words the model would be mostly right.

So if these people are right, why did they blow up? Answer because they ran out of money!!!! It is that simple... People get so enthused and they think they just invented a new way to print money.

Thus I came to the conclusion that the style of trading really does not matter. You could use astrology and the orientation of Saturn to Jupiter and with the right money management approach you will make money. If you think I am being crazy talking about Jupiter and Saturn, well explain to me "waves" and "fibonacci". Those approaches are downright loony. Yet there are people who believe in waves and real money managers who invest in waves.

So how come waves work? Obviously they do since some people make money. Answer, because unlike real science the market is a psychological tool where the answers lie in self-reinforcement. If you and many people believe that waves work, well then by golly waves will work! Even if there is no scientific basis to it whatsoever! But they will work until they don't anymore.

This then lead to me question what is consistent and has worked throughout history? Answer the mania of crowds! Single people can be rational, but a crowd is irrational. It does not matter if you went back a 100 years, or 400 years irrationality and manias are all the same.

Thus my investing style is 100% based on feeding on the mania, by taking the other side. I invest or trade in the sides where people are not willing to go because their fear does not allow them to go. Most people call that buy low, sell high.

Classic example Intel vs AMD. AMD is a dog of a company, and if you look at their balance sheets or their stock price you would go screaming into the night. Yet look at the yearly stock performance of AMD vs INTC. No comparison. Why? Because of the lunacy of crowds. I invested in AMD and kept averaging down since I knew that AMD would be back, and I made more money with AMD than Intel (even though I owned both).

Or how about Palm, another company that I owned? I bought it on the cheap and watched it run up and become a momentum play.

Another fav for me is Crocs! In my own crowd of friends I had to endure a year of heckling before I doubled my money.

And one final one was selling Feb 1700, and June 2200 gold options for 0.90 cents. At the time gold was trading around 1,000.

My point is that yeah I am stubborn about being right, but I buy what is unloved, or the result of a mania.

Warren Buffet in one of his characteristically shrewd moves provided expensive insurance to Florida after the devastating hurricanes. Many might have considered Warren as loony, but he calculated his odds and won (yet again).

So if it was this easy why does not everybody do this? Simple answer psychological and the reason why we are having this very very very long discussion. As the contrarian book says, it is much easier for humans to be wrong as a group, than right as single person. It is part of our evolution and makes quite a bit of sense. But it is that evolution that is completely wrong for the market.

Does it mean I am always right? Nope... I have eaten large percent losses in C, and GM, but those positions were risk managed and I did not care since others more than make up for them.

 

Why only IB? Does it have anything to do with the broker giving you control of how positions are liquidated?

 

IB charges 1 USD minimum per trade. Since I have an upper limit of 200 USD per trade that represents 0.5% profit. Now imagine you were charged 7 USD, then you would have to eat 3.5% profit. If I was charged 7 USD per trade I would need a 7 digit account to make my strategy work. I don't have a 7 digit account, just 6 digits...

Because IB charges such low commissions there are many strategies that you can implement on the cheap.

 

"We didn't lose the game. We ran out of time!"

 

That's funny....

 

And example of using averaging down at the wrong moment...

As I watch this Joe Terranova said on Fast Money that he was doubling down on Apple...

In my opinion this is why people blow up their accounts. Of course I don't know his allocation profiles nor his risk. So maybe he is ok because he has been nibbling.

However, if this were a trade for me I would be running screaming into the night. I personally feel you don't ever double down on momentum trades (if I was to do a momentum trade).