Averaging Down - Ineffective Trading Methodology

Averaging Down Definition

Averaging Down is the process of adding to a position as it goes counter to your initial transaction. In theory this makes sense because it will allow you to obtain the same asset at a cheaper price. Therefore, you are able to average down the entry price and in turn increase the profits when you close out the position. The major flaw in this strategy is that you have know clue which of your trading dealings will respond accordingly and rally in your favor, and which one will continue to slide lower.

Cut Your Losses

If you are reading this article, odds are you have heard the old adage of cut your losers and let your winners run. This sounds easy enough, but why is this so hard to do? It is a basic part of human nature to hope. Once you have accepted a loss for what it is, then trading becomes one of the easiest business operations you could ever undertake. The problem with so many of us, is that we can not let go of the hope. Therefore, when we clearly see the stock is no longer in our favor, instead of taking the loss, we do the "smart" thing and add to the position. Investors use phrases like averaging down to justify there reckless actions of not only holding onto a losing position, but also adding to them. Let's just step back from the trading game for a second and let's put this another way.

Would You Average Down with any other business?

To simplify the concept of averaging down, let's say you owned a small house wares shop. You sell all types of products, but you recently added a new style of toaster that is going to change how people eat their breakfast. You place the toaster in your front window with banners and ribbons, but in your mind you think this isn't necessary because the toasters will sell themselves because you believe in the product so. However, to your surprise you were only able to sell 1 toaster in an entire week. You look over your inventory sheet and you realize that you have 499 toasters left to sell, so you begin to worry a little and a phone call to the supplier is in order. The supplier empathizes with your concerns, so they offer you an additional 20% discount to improve your margins. This time you know that things will be better because you can average down on the price you paid for the toaster. In your mind and heart you know that the only reason the toaster is not selling is due to the price. So, you take the supplier up on their offer and you purchase an additional 1,000 toasters, because you would now have 2/3 of your inventory at the discounted rate. Then to your surprise, there is no additional interest in the toaster and you are still unable to sell any toasters. What would you do at this point? Would you average down again?

Averaging Down