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.
