Should you average down in a trade or investment? A big question that many people have. They play place a trade, then it starts moving against them. They then start thinking whether they should average down for long trades, or averaging up for short trades.
After all, if you average down, your average price for the shares lets say goes down. If the average price goes down, then all you need is a smaller bounce back up and you can get to break even or to profit. Sounds seductively amazing?
Only problem is the more you average down, the more of your portfolio and equity in your account is at risk. Any further market moves against you have a much bigger impact because you have increased your position size. Also if the market has moved against your initial position, what makes you so sure that now after you have loaded up on a bigger position that the market will move in your favor. You need to ask the right trading questions. After all the market doesn’t care how big, or small of a position you have. Well, most of the time the market doesn’t care how big of a position you have, but with hedge funds running multi billion dollar positions, sometimes the market does care, but that is for another article.
If you do plan to average down and put on a bigger size than what your risk parameters state, then you should at least have the order flow and liquidity on your side.
Typically trader psychology and money management techniques teach that you should not average down. And for most people this is sound advice as they do not want to blow up their accounts. They want to keep your account near it’s initial value so that when they learn the trading game, they can place the good trades with their full account equity and a not a depleted capital base.
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There are however a few, or many exceptions to the never average down rule.
If you have a trading strategy where you clearly define that you will use a scaling in type entry strategy, then averaging down or up is perfectly normal. This is assuming you have clearly positioned size to reflect this trading strategy.
If you have clearly defined what your position size will be at the various entry points, and what your total position size can be for the trade, then you can take no more risk than the other traders who are getting all in at once with one trade.
Let us say that you determined on April 26, 2011 that the Euro may experience a drop. But you do not know the exact timing of the move, nor what price the Euro will top out at. Thus you do not want to get your full position size in all at one price. You don’t know if the top will occur all in one day. So you decide to prepare a scale in type of short strategy where you start selling EUR/USD every 100 pips. You start building up a short position at 1.4700, and start adding every 100 pips to your short. You get in one-third of your position at 1.4700, another one third at 1.4800, with the final one third position at 1.4900. Lets say you have a stop loss for all the positions at 1.5050.
Let us say that you have an account size of $100,000 and choose a maximum of 3 standard contracts as your full position size. So you sell 1 standard contract at 1.4700, followed by one more short contract at 1.4800, followed by the last short contract at 1.4900. You have achieved your full position size of three standard contract, but you have scaled into the short position. In other words you have averaged up.
In the above chart, I have shown the potential scale in strategy you could of used in the Euro.
If you had a $100,000 account and traded 3 standard contracts you would of:
- Shorted 1 standard contract at 1.4700
- Shorted 1 standard contract at 1.4800
- Shorted final 1 standard contract at 1.4900.
- Stop loss at 1.5050 lets say
Total risk for the trade if all three standard lots got stopped out at 1.5050 would be a $7,500 dollar loss.
Now contrast this with the other type of trader who just likes to get in the full position all at once. Lets say the same trader made the decision on April 25 that the Euro should go down. They choose not to use a scale in strategy. They should to just short 3 standard lots all at the 1.4700 price. They too risk $7,500 so their stop loss would be at 1.4950. In this particular market scenario the stop loss almost got hit.
Now in the end both types of traders still made money, but the scale in trader made more money because they got in some of their short positions at higher prices, while the all at once trader shorted the full position size at the 1.4700 level.
There isn’t anything wrong with either the scale in or all at once approach. Both of those entry techniques can benefit from having better market timing.
Don’t let anyone tell you that averaging down for long trades or averaging up for short trades is a bad strategy. It can be completely viable if you have positioned size for the scaling in of the positions and still control your risk. The people telling you that you should not practice averaging down probably have very little knowledge about scaling in and position sizing.
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