Why you should average up, NEVER down

Discussion in 'Risk Management' started by garfangle, Jul 9, 2010.

  1. A reason why traders blow up is because they average down their trades, when they should instead average up.

    It is tempting to accumulate more stock when the price falls, but this strategy is wrong because human psychology cannot handle the pain of severe drawdowns. Also, you cannot implement a stop loss order to protect your account if you average down because the stock can always get cheaper and then you are stuck once you have no funds left to average down with.

    The alternative is to average up and accumulate stock as it rises. Even though your cost basis rises, you can implement a stop loss order strategy if the trade goes against you. Therefore, you rarely suffer punishing drawdowns that cause you to cry uncle and wipe out your account.

    The danger of an average down strategy is you have no point of reference when you should acknowledge you are wrong which allows you to cut your losses before they snowball.

    Assume:

    -initial $100 stock
    -100 share order
    -(pain threshold at $50)

    price falls to $90, do you accumulate more or sell?
    price falls to $80, do you accumulate more or sell?
    price falls to $70, do you accumulate more or sell?
    price falls to $60, do you accumulate more or sell?

    Even though your cost basis falls, you are accumulating ever greater losses and have no reference point when to stop. Moreover, you cannot assume the the stock will recover enough to get you back to break even.

    The advantage of an average up strategy is there is a point of reference when you know you are wrong and the price at which to sell.

    Assume:

    -initial $100 stock
    -100 share order
    -stop loss $90

    price rises to $110, do you accumulate more or sell?
    -you accumulate more and set a stop loss at either $100 or $105 (break even)
    price rises to $120, do you accumulate more or sell?
    -you accumulate more and set a stop loss at $110
    price rises to $130, do you accumulate more or sell?
    -you accumulate more and set a stop loss at $115
    price rises to $140, do you accumulate more or sell?
    -you accumulate more and set a stop loss at $120

    Even though your cost basis rises, you know where your break even price is at and can adjust your stop loss accordingly.
     
  2. +1

    'keep what shows you a profit sell what shows you a loss' Livermore
    Anyone who has made big money in the market has used this technique you describe. Most here will never do it..its a tough thing mentally to crack. But, once you have done it ,you want to keep doing it- pavlovs dog syndrome.Just keep doing it on a simulator until you feel you can do it for real.What is hardest to do is what will seperate you from the 90% losers
     
  3. I've been avg'ing up and down (with very strict rules for doing so) for over a decade with very nice results.

    Your opinion is fine, but that's just your opinion and not fact.
     
  4. Many ways to trade and each to their own etc but for most people most of the time averaging down is a losing strat. But having said that i also have/will ave If for example i want to buy 1040 but i dont think it will get hit so i buy too early at 41/2.In that case,if i add at my original intended price (40) then the reason for the trade is still valid and my stop is not hit.In that situation should we go back to 41/2 i could close my initial entry at b/e and keep 40 running,so reducing the risk.
    Planning to do that in advance is a world away from averaging down because you can't accept a loss.
    As you say,strict rules,and in trading you make your own rules
     
  5. I agree, but the title says NEVER. And my point was, never say never. Some of us have figured out ways to be successful doing the things that most people say never to do.

    :)

     
  6. totally disagree. if you have no funds left to keep averaging down your plan is failed. if you have no stop your plan is failed. using small portions to accumulate a position and end up long near the bottom or short near the top is a good way to trade provided you have a concept of risk management
     
  7. Garfangle,

    I never thought of that! That's the best concept I've read here in a week.

    If a stock goes from $5 to $4 and you average down to a price of $4.50...your problem then is that your cost basis is above the stock price, so setting a stop loss isn't possible without guaranteeing a big loss. And you're doubling your bet on a loser.

    But if the stock goes from $4 to $5 and you average up to a price of $4.50, you can set your stop loss at $4.50 and never risk losing a cent. Here you're doubling your bet on a winner.

    I like it!

    SM
     
  8. My dream trade is catching a 1000pip move in forex and averaging up every 100pips or so!
     
  9. Another benefit of the average up strategy (AUS) is that your break even price is lower than the current price (assuming it initially rises) whereas in an v. average down strategy (ADS) your break even price is higher than the current price.

    Meaning that in an AUS to arrive at the break even price the stock has to go AGAINST you (assuming you are long). In an ADS to arrive at the break even price the stock has to go WITH you (assuming you are long). Therefore there is room for error with an AUS and just hope with an ADS.
     
  10. Pekelo

    Pekelo

    Just to be contrarian (my nature):

    When the market turns while you are averaging:

    AUS : you are loaded and it starts to go against you suddenly.

    ADS : You are loaded, but it is going in your way finally...

    There is nothing wrong with averaging down, if it is done at the right time (choppy markets) and not too excessively.
     
    #10     Jul 9, 2010