Averaging Down
November 14th, 2006 by Justin
This issue is one of the more divisive in the trading world. Few traders have a middle-of-the-road view on it, and perhaps with good reason. Some of the most notorious hedge fund collapses in history, including Amaranth and Long Term Capital Management, have been partly blamed on strategies that involved “throwing good money after bad.”
[For the uninitiated, the basic concept behind averaging down is to “scale” into a position and thereby improve one’s entry price. If you purchase 100 shares of GOOG at 466, and another 100 at 430, your average price will be 448, which is a vast improvement on your initial entry. Overeager traders use this as a “crutch” that allows them to take small initial positions to avoid missing out on potentially big moves, and then add to those positions if the trade moves against them. Others who are carry trading might take the interest they are earning and “reinvest” it in the position, even if it has moved against them in the meantime. In a market like foreign exchange, where the bid-ask spread is the primary cost of a trade, averaging down becomes even more cost-effective, in that no additional commissions are being paid each time a new portion of the position is taken on.]
The crux of the issue is this: Those on each side of the debate have vastly differing perspectives. Traders who argue that averaging down is senseless folly do so usually from years of experience. They have lived through or witnessed a massive blow-up caused by a small, short-term losing position becoming a long-term position becoming an increasingly large and overwhelming loss. On the other side are those new to the markets and still in the process of developing a strategy. They see averaging down as a cheap way to get involved in a trade without committing to a “full” position, and to allow the trade some room to manoeuvre before adding to it.
The answer? In the end it all has to do with motive. I stand by the trading epithet, plan your trade and trade your plan. If your trading plan involves averaging down, so be it, as long as you stick to that plan when actually executing. The absurdity of averaging down comes into play when a losing position is added to out of despair, rationalization, or hope, all of which kill trading plans and traders.
