Lead Snap
Averaging Down Can Bring You Trading Losses
The area of trading money management is first and foremost supposed to help you get a grip on trading losses. Good policies are what you need to make sure that you don’t have to lose more than you can manage. Sadly though, some strategies are more destructive than helpful. One example of a dangerously counterproductive technique is averaging down.
Traders who average down buy more units of a stock that is already moving down. To most observers, this may seem like an illogical move. It is indeed a technique that defies logic but traders who practice it don’t realize that. The main reason why they apply it is that doing so lowers the average cost per unit. Hence when traders analyze their data for investment losses and profits, they will see that they were able to buy units of the same stock at a far cheaper price than the original. This is where their analytical skills get blurred.
Common sense can easily point out where averaging down goes wrong. This method does reduce average cost but you shouldn’t expect profits to be within your line of sight. Buying units of bad stocks is just a way of increasing your losses.
There are deeper reasons why investors adopt this strategy despite its obvious deficiencies. Stubborn supporters of this strategy deny that they are losing and are taken over by a desperate desire to regain their stock trading losses. They can’t see how mistaken they are because their feelings have gained mastery over them. They are too emotionally disturbed to pull themselves back to logical ways of thinking.
This is what makes addressing trading psychology important. Before traders even start trading, they should set the right mindset. The best psychological state to adopt is one that does not leave space for emotions to play. Decisions should be supported by facts and research. Moreover, they should be guided by a strong trading system that has been back tested.
Taken as a whole, the parts of a trading system take charge of limiting trading losses. One element that can address the tendency to average down is money management or risk control. When you’ve made the rules for money management, you’ve also effectively set the levels of risk that you are comfortable taking. You will therefore never have to live through losses that are too huge. To set your rules, you just have to identify your trading float, trade size, stops and maximum loss.
You can also incorporate averaging up into your risk management plan. This is clearly on the opposite end of the spectrum as averaging down. If averaging down is illogical though, you can expect its opposite to be logical. Averaging up can be a bit costly but it is still a good choice. This is because what you are doing is buying into an already profitable position.
It may not be easy for some traders to take the best path to cut their stock losses. This is especially when emotions are already part of the equation. When temptation looms, firm risk management rules are the only points that can secure logical thinking.
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