Why you should average up, NEVER down

[cherubian]

It all depends on strategy and type of trading being done IMHO. People should understand the fat tailed distribution found in all mkt price data across all timeframes, and realize those fat tails is what makes averaging down dangerous if done improperly. If mkt data conformed to standard distribution, averaging down would always work. Have to decide where you are going to make and lose money = the fat tail, or the bell curve. Each has its benefits and weaknesses.

http://www.elitetrader.com/vb/showthread.php?s=&postid=2311344#post2311344

 

[rosy2]

Quote from NY0BScalper:

If I have no idea about a stock's direction, except that it will maintain a 30 cent range, how do I profitably day trade it? My stop loss is based on an unexpected range expansion.... and this is an equity daytrade, not an option trade. I say "hey this stock will probably stay between 20.20 and 20.50 all day, but I have no idea where it will go between those numbers and how it will gyrate." How do I make money with this info?

was this rhetorical? i have a program that trades precisely this type of pattern

 

[tomahawk]

Averaging down can be risky business. But if you insist on doing it, here are several rules which I believe can help you avert disaster:

1) make sure your market is normally a mean-reverting instrument such as an index or broad ETF
2) make sure to scale widely enough to make your 2nd unit extremely likely to show profit (I do not recommend averaging down more than once per trade)
3) have a pre-planned stop loss for the entire position
4) exit before your stop is hit if the market shows evidence of runaway momentum against you (news shock, etc.)
5) you are trying to pick a top or bottom, so once you are green make sure you hold some well past your B/E to help counteract the large losses you will occasionally experience. You do not want to be averaging down into huge unrealized losses and then exit with just a few ticks profit ... this will kill you over time.

Edit: I have mentioned this before - several S&P pit traders I know do average down regularly. (They also average up.)

 

[NY0BScalper]

Quote from rosy2:

was this rhetorical? i have a program that trades precisely this type of pattern

I was being rhetorical, I trade that way manually and am looking to add more automation. I don't worry too much about edge saturation because it's too hard to teach and requires too much feel on the risk management side when it's not working right.


I loved your answer, ammo!

 

[deadbroke]

Quote from garfangle:

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.

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HERD member talk. The HERD rule is simply, "Never add to a loser" .... ditto for everything else in life (except for supermarket shopping and fat chicks. )

But by definition the HERD cannot TIME. Timing is taboo at ET, yet it is the only thing that could eject a member out of the HERD and save him= individualize him.

Timing is a skill, but the HERD by definition, can only REACT=FOLLOW, so expect 1000s more threads on STOPS, TP et al ad infinitum.

Watch ET in the picture below. Only the first jumper CAN be converted to an individual but even this would be hard work due to the fact that he never sees the crocs in the first place until too late.



Uploaded with ImageShack.us

 

[coolweb]

Quote from NY0BScalper:

If I have no idea about a stock's direction, except that it will maintain a 30 cent range, how do I profitably day trade it? My stop loss is based on an unexpected range expansion.... and this is an equity daytrade, not an option trade. I say "hey this stock will probably stay between 20.20 and 20.50 all day, but I have no idea where it will go between those numbers and how it will gyrate." How do I make money with this info?

I got a suggestion: don't trade it?


Theres empty coke bottles worth 5 cents in garbage cans, do you pick these up all the time as well?

 

[Redneck]

May be its just me – but I would be Thanking NYOB and Ammo about now….

eta - Working your way out of a losing position is possible - worth understanding what was posted for a couple of reasons...

RN

 

[coolweb]

Quote from Redneck trader:

May be its just me – but I would be Thanking NYOB and Ammo about now….

eta - Working your way out of a losing position is possible - worth understanding what was posted for a couple of reasons...

RN

Deadbroke is a much better read. Ammo and NYOB are blowups around the corner.


Traders most valuable edge is timing, sadly Many traders aren't even proficient in the basic "requirements" to make it in the business.
So they average down, because they are too lazy to past basic bootcamp.

 

[joneog]

Like others have said, it depends what the market is and what it's doing. If it's chopping averaging down can work, if its trending averaging up can work. If only it was easy to figure out whether we will chop or trend on any given day.

Since a lot of people don't fade the chop averaging down is usually not a good strategy for them. If you initiate a trade and you start losing on it immediately (not just a few tics) what does that tell you about the trade? Either you're early or wrong. If you're wrong you should be getting out not getting deeper in. If you're early you wont know it until after the fact so why increase your risk on a trade that hasn't proved itself yet. You're putting yourself in a bad spot psychologically by taking a loser and making it a bigger loser, with a chance to get even bigger.

It's better paying up a few more tics and being right on the trade, rather than getting a better entry price that ends up as a losing trade anyway.

The major problem I've found with averaging up in the index futures for example is the fact that at the start of most good trends the market will have strong retests that go to your entry or worse, so if you add on the first move higher(lower) your new higher(lower) avg entry will put you in a tough spot on that first retrace.

 

[jajuanm2]

Please keep an open mind. I could give many examples of people blowing up that don't average down also. I know all the books teach to not average down, but many great traders average down (aka scale in around support and resistance levels) The key is still to keep the total average risk under 1 or 2 % of your total equity. Not sure how you can blow up if you average in a couple of times and your total risk for the position is kept under 1%. Trading is a great paradox where what appears wrong is sometimes right and what appears right is sometimes wrong.

Quote from coolweb:

Deadbroke is a much better read. Ammo and NYOB are blowups around the corner.


Traders most valuable edge is timing, sadly Many traders aren't even proficient in the basic "requirements" to make it in the business.
So they average down, because they are too lazy to past basic bootcamp.