Last week, I covered some of what I consider to be the most deadly trading sins. These sins won’t kill you, of course… But they can absolutely kill your trading account and should be avoided at all cost so your portfolio can live to trade another day.
And today I’d like to expand on one of the trading sins I mentioned… what’s known as “averaging down.”
In my strategies, I give unit sizes for putting on trades, and often later I will add to those positions. The point being, it’s never wise to go all in on one trade.
More often than not, your first price is not your best price. And if you leave yourself some dry powder, you’ll find that you can add to a winner that’s trending higher.
As I mentioned last week, I’m not a fan of averaging down. But there are situations where your trade might get hit with a newsbomb that will be against the trend for a short period, and it might be wise to add and fade that move.
Averaging down is a strategy some traders use to lower their average purchase price on a stock that has fallen. Simply put, you buy more shares or options contracts of a stock that’s lost, hoping the price will rebound and allow you to recoup your original investment faster.
This strategy can also be risky…
The biggest problem with averaging down is it can lead to even bigger losses. When a stock price drops, it can be hard to accept the loss and move on. And the trades I put on are supposed to work soon after if not right after issuing them.
Averaging down can also give traders a false sense of security, leading them to believe that the stock will eventually recover. Instead, the stock may continue to fall, resulting in bigger losses.
Another issue with averaging down is that it can tie up capital that could be better used elsewhere. When you invest more money in a losing stock or option play, it leaves less money available to invest in other opportunities that may have a better chance of success. This can limit your potential gains and lead to missed opportunities.
I’d much rather focus on new opportunities than trying to prop up a loser with more capital.
Of course, averaging down can work in certain situations. Like I mentioned above, if a stock gets hit out of the blue by some newsbomb that temporarily sinks it, it may be a good time to average down.
However, if the stock is falling due to company issues like poor financial performance or management decisions, it’s probably better to cut your losses and move on to the next trade.
In the end, the decision to average down should be made carefully and with a full understanding of the potential risk-reward.
It’s important to have a clear exit strategy in place and to only average down in certain situations where it makes sense. Ultimately, successful trading involves a balance of taking calculated risks and protecting your capital. So if you choose to average down, make sure you do so carefully.
Jeff Zananiri
Jeff Zananiri Trading
*This is for informational and educational purposes only. There is an inherent risk in trading, so trade at your own risk.
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