Quote from Candace:
Christian, thank you for your responses. I appreciate the help in trying to sort this out. (Thanks PA and RN too).
Simplistic as I am, I think of risk being increased whenever position size is increased, regardless of the current profit/loss on my trade. But I am not just simplistic, I am emotional and at times act illogically.
You however seem to be a methodical man. Any chance you could expand upon your statement that with your style of trading, averaging up increases your risk (more than does averaging down)? If itâs not too much to ask, perhaps something more detailed than âthe numbers showâ.
And just in case you suspect that I am quietly mocking you, let me be clear. I am mocking ME.
Here is the situation. Let's say that you have a stock. You can't predict whether you go up or down. However, most technical analysis and people do try to predict. So now you are caught in a bind because any money you put into the market is a crap shot.
So assuming that there are crap shots, the question becomes how do you build high probability trades that will make you money?
One way is momentum, where you apply the bigger fool theory. In other words you step into a stock that has momentum in a certain direction and you get out a bit later, but before the masses do. If you like momentum you listen to people like Garth.
Another way is contrarian. Contrarian is when you buy on the cheap. You buy what everybody hates, or has blood. With contrarian your only risk is your pyschology. It is hard to jump into a trade in a true counter trend. Contrarians are people like Warren Buffet, like when he doubled down on GE. People were literally calling the old man a fool. Yet he did because he was running counter trend, and is quite richer because of it.
So now let's say you are going to run a momentum trading system. You are going along a trend, and will exit the trade when the trend stops. Thus your way to make money is to keep adding money as the trade becomes more profitable, and instantly exit when the trend is done. People will add more money in this approach, but they will refuse to exit the trade because they believe they can squeeze that much more money out of the trade. Here is where I believe most people say, "oh I will just average down" even though that is NOT, and I mean NOT the thing to do. You are supposed to exit!
In a contrarian system you have picked a stock that you believe is a great investment. However, the market for whatever reason believes it is not. Hence the price goes down. It is at this point you say, "no I want to buy." Momentum, like contrarian rely on the bigger fool. Whereas contrarian relies on the bigger fool to bring market down further.
So as the price keeps dropping a contarian system will say buy more stocks. And this is where things become hard because the further the stock falls the more you have to analyze your risk position. Is your position too big? Are you willing to further hold or add? If as a contarian you decide to exit it is due to fundamentals, and not some arbitrary stoploss.
So why not add onto your position as the stock becomes profitable in a contrarian system? When the stock becomes profitable you are in fact relying on momentum to carry you to exit position. And because momentum might be short lived you might have to average down further, until it eventually causes your position to exit.
The trick with momentum is to exit the position and not let greed take control. And the trick with contrarian is to control the position and not let fear take control.
Blow up's happen for a multitude of reasons. But among retail and smaller investors I believe it is because they can't get their strategy right. Momentum is not contrarian and contrarian is not momentum. You can't mix the two strategies and you can't truly be somebody who plays both strategies since their pyschology's are completely different.
Thus you need to identify momentum play and contrarian play. The stock market from November onwards was momentum. The market from November 2008 to March 2009 was contrarian.
Amazon at 100 and above is momentum, whereas Amazon at 30 is contrarian.
A classical contrarian play last year for me were the automakers. I bought GM, Ford, Mercedes, BMW, Fiat, and Renault. All of them were bleeding money and it seemed that they all would go bankrupt. One did GM, and I lost 75% of my investment. However, I more than made up that with Ford 500%, Mercedes 35%, BMW 89%, Fiat 87%, and Renault 20%. So how come I made less money with Mercedes and Renault? I reached my risk limit and said, "either they make or they don't"
Are there any contrarian car plays now? Sure, one company Volkswagen... Nobody wants to touch this stock because the company is "problematic". I agree Volkswagen has problems, but Volkswagen also has some incredible potential once they get their head screwed on right.
Regarding a previous comment and LTCM. The real reason why LTCM blew up was not averaging down. Yes they did average down. But LTCM controlled too much of the market and had many players work against them. Had LTCM stayed a certain size they would probably still be in business today.
Does this help? Or still wondering?
