In this video we're going to look at a common trading bad habit; averaging down.
What it is and how we can take steps to eliminate it. Hello I'm David Jones from
Capital.com and this is one of a series of videos that we're doing where we're
looking at trading biases or trading bad habits. Our trading platform has an
algorithm that will look at client behaviour and if it detects that maybe
they're slipping into bad habits we'll try and push them in a different
direction, to make them aware of the biases that they're developing. This time
around we're looking at the idea of averaging down. So first of all, what do I
actually mean by this. Let's take a look. So let's explore this trading bias of
averaging down. Let's go through an example, let's say - let's stick with
shares for now to keep it simple - let's say you buy a thousand shares in a
company at $50. Because you're expecting the price of course to go up. But you're
wrong, the price falls to $40. So what you do now [is] you buy an additional thousand
shares at $40 this is averaging down - not I am recommending it as an
approach. Your average price is now $45. So you bought a thousand at 50, you
bought another thousand at 40, so your average price - because you bought the
same amount- is the average of those two numbers, which is $45. So why does this
appeal to people? Well if you have a conviction in your trading-investing
view on that particular market, whether it's a share, or currency, or a commodity -
as we saw in the previous example it does end up giving you a lower
break-even point. Assuming you're right on the ultimate direction and if we go
back to that previous example, assuming the price does recover, you're gonna make
more profit on your holding because you've bought more and you've ended up
with a lower average price. However, in reality it's often a sign that someone
cannot admit when they're wrong and take that first manageable loss.
They've got an aversion to losses and may just be gambling. So they bought
in at 50 because they thought 50 was a good price, rather than maybe having a
stop-loss, they bought some more they - averaged down. One way of comparing this
is the martingale approach in gambling. We talked about gambling here, where
people will double bets after a loss, and continue doubling their stake hoping
they're going to cover that initial loss. So in a nutshell it's adding to a losing
position as the market moves against you. That's the theory - let's take a look at
an extreme example in the real world. Let's take a look at the risks of averaging down.
I've got a US stock: General Electric here. Let's go to the
right-hand side of the chart, May 2017. The price is just below $28, you decide
to buy in. So let's say you buy some shares at $28, you buy a hundred shares,
so that's $2,800 invested. Let's jump forwards a few months. It's now July 2017.
The share price has slid, it's now trading around $25.50. You still have the
conviction so you decide to buy another hundred shares at 25.50 - this does bring
your average down but you're adding to a losing position. Let's jump forward a few
months again. It's now October, the price has slid further, so you bought initially
at 28, they're now trading just above 23, you decide to average down again. And a
few months later the price is now trading at $18. So you need - if you want
to average down - you need to have more money again and you're adding to this
losing position, just look how far they've slid from that $28 mark. It would
have been much less painful to have had a stop loss when the trade was opened
and come out for a manageable loss, rather than adding to the losing
position. And just to bring it up to the present day - at the time of recording - the
price was trading at $12. So it's more than halved from where you bought that
initial bunch of shares at $28. So this is an extreme example but it does show
you the danger of adding to a loser; you're compounding your losses if the
market continues to slide and you're tying up money that could
be used probably much better somewhere else. So that was an extreme example but
you can see the risks. If the market continues to go against you, you're just
throwing good money after bad, and tying money up. So let's now take a look at the
steps we can take to make sure we don't get into this bad habit. So we've
identified why averaging down is a problem for some traders because it
means they're trying to avoid taking losses and taking small manageable losses is
all part of trading. So when trading have a definite stop-loss level. If we're
buying at $50 in that example and we decide at $47 - if it falls to there I'm
wrong - have the stop loss level there. If the market gets there take the loss.
Don't add to losing trades. If you've bought in and the market's sliding and
you're continually adding, you're clearly adding to your losing position, and if
you want to carry on averaging down you may need an enormous amount of money if
the market continues to slide. So it's often a good rule not to add to a losing
trade - don't dig yourself deeper in the hole. Averaging up, however, is different.
If the market starts moving in your favour there's nothing wrong to
having an approach and a plan to add in to your position. The market has started
going the right way - the initial trade is winning - so you can
always think about averaging in that way. So it's a cliche in trading but very
often the first loss is the best loss. Averaging down is really just
compounding that loss so it's something as traders that we really do want to try
and avoid. I hope you found this video useful, they'll be a whole load more
content that we'll be doing on this topic. So to never miss out just make
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