Averaging down. Everybody's done it. The question is whether or not this is a good strategy for your trading. In this article, we'll look at some of the pros and cons and then dig into some of the deeper underlying questions.
It's called by various names: averaging down, dollar cost averaging, tranche. But the idea is the same. You enter multiple positions on a single financial instrument with the expectation of making a profit.
On the above chart, the two yellow circles represent long entry positions for ITEK as a day trade. After the first entry, price goes up a little and then it abruptly retreats. Let's say the trader makes a second entry with the same amount of equity inside the lower yellow circle. The trader hopes to make a profit, or at least break even on the trade, by entering a second position at a lower price. (I go deeper into this chart analysis in the YouTube video posted at the bottom of this page.)
So let's talk about the pros and cons of doing this.
1. On the plus side, the trader in the above example could have gotten back close to break-even on the trade if they exited the trade near 13.80. So, sometimes this strategy works out. And that's the problem. Sometimes we get lucky in trading and we end up creating a trade management style based on the fact that sometimes we get lucky. That's a bad approach. If you want to use this strategy, then you need to take an objective look at your results and study the probabilities of this working out for you.
2. On the plus side, we could argue "a perfect entry price is always impossible, so I will create multiple entries if price moves against me". It is true that a "perfect entry" is close to impossible in trading, but that doesn't mean we throw out all technical analysis and make haphazard entries. Accepting price volatility is part of trading. The tendency of most traders is to enter a second position much too close to the original position rather than giving price a little bit of breathing room.
3. If you are trading with the trend, then splitting your position sizing into a two-entry order system can work. I know that sounds complicated, so let me explain. Let's say you believe that ITEK is in a bullish trend. But you also recognize that it is a highly volatile stock. If your average position size for each trade is $10,000, then you might enter only a $5000 position at first and remain open to entering a second position later on. While I am not advocating this type of strategy, this approach removes some of the problems associated with dollar cost averaging. Most traders use the same equity position on each new entry. By doing this, they take on more risk than their trading plan allows. They move out of their comfort zone and they begin to trade emotionally. With so much at stake on this one trade, they lose focus on the technical aspects of the trade and the emotions of fear and panic soon follow. Knowing this, using smaller position sizes might help you control the emotions if you are person who tends to average down.
Overall, my opinion is that averaging down with day trading is a risky business. If it works out, then it encourages sloppy trading. Most second (or even third) entries are based on emotions rather than being based on technical analysis. And I think the trader who does this too often is playing with fire and will get burned over time.
When we enter multiple positions, it also points to some bigger problems with our trading. Trading is not throwing darts. My bias is toward technical trading. This means that I study the charts and I look at areas of Support and Resistance before making any trades. In the Day Trading Pro chat room that I lead, I often talk about "the basis for the trade". For example, the basis for a trade might be that "price will find support at the Pivot Line". Well, if price falls through that Pivot Line and it doesn't find support, then the basis for your trade has been violated. Do you enter a second position after being wrong or do you exit the trade with a tight stop loss since it didn't do what you thought it would do?
More questions...if you enter a second position, is it because you cannot accept the fact that losing is part of winning the trading game? We are not going to make money on every single trade. It's not going to happen. And if your fear of losing money is so great that you cannot accept these small losses, then you are not going to make it as a trader. The key, as I'm sure you've heard before, is to keep your loses small and let your winners run. The fact is that most traders do the opposite of this. They panic when they see a profit and they exit the whole trade since it worked out. Then they average down on the losing trades because they cannot stand the thought of losing money. Catastrophe is not far behind.
So, to conclude this article, let me first point you a series of six free videos in which I talk about Support and Resistance. That series is available here: averaging down vs. Support & Resistance. Support and Resistance is the foundation of all technical analysis and this video series is a good place to start. Second, let me leave you with a few questions.
1. Does averaging down work for you? If you average down, then have you measured your success: failure ratio? How often does it work out? Is it worth the effort?
2. Does averaging down encourage sloppy trading for you? Once you get in the habit of using this strategy, then the tendency is to slack off in your technical analysis. Only you can figure out if this is true for you or not.
3. What is the psychological impact of averaging down? Does this strategy build your confidence as a trader or does it tear it apart? Are you more emotional when using this strategy?
I have done dollar cost averaging myself. I did it more when I was first starting out as a trader and then I learned the hard way that it wasn't a good strategy for me. Overall, I think dollar cost averaging is less risky as a swing trading strategy than as a day trading strategy. But even there, we have to be careful because we simply hate to be wrong as traders. We hate to lose money. And we have an incredible capacity to rationalize our behavior. In the final analysis, we are responsible for our own trading decisions and we are responsible for creating trade management systems that help us increase our probabilities for success.
The following YouTube video covers this topic but also gives more chart analysis: