Many traders believe that averaging down is a wise way to improve the potential of a profitable trade. It is true that this method can be useful, but whether it is a viable option in long-term trading is questionable.
This action is done by adding to your initial position, particularly when it begins to counter your original prediction, allowing you to buy an asset back for less. By averaging down the entry price, you will obtain higher profits when the position closes in that counter-direction. This is just one of the many trading strategies used in the industry, but it does hold high risks and unpredictability as a trader cannot be certain if the trades will continue in that counter-direction.
The reasoning behind the risk
It seems futile to insist on holding onto a potentially doomed trade. However, people are not fond of the concept of cutting their losses. Instead, many people try to turn the situation around wherever they can. In the trading industry, this is not the best mindset to have; a loss should simply be seen as a loss. Rather than a strategic technique, it is a means of holding onto the hope of eventual success, regardless of the existing failure. This is often seen as the human aspect of trade, which is compounded by a hopeful belief that it will turn right in the end. However, these actions are the reason that some consider trading a form of gambling.
The 2008 Mortgage Crisis
The Mortgage Crisis that occurred in 2008 is a prime example of using averaging down. A massive selloff took place as the market continued to drop at a drastic rate. Many traders decided to buy into stocks as they were plummeting, considering the price was less than their entry price. While it is true that the market did eventually recover, it is far from wise to place buy orders when a security is priced at less than half of your initial entry price.
Averaging down from a strong position
Contrary to what most traders think, averaging down is best done from a position of strength rather than weakness. Many pieces of Forex and CFD advice would advise traders to use techniques like this when conditions seem dire. However, when a stock is following a strong trend, that is a better time (if ever) to average down. If the trend is heading toward breaking out of its intraday or monthly average, averaging down could be beneficial, particularly in smaller intervals of time.
Traders can choose between two methods to close trades. Before choosing, you will need to review your trades and determine which one is most applicable. The first method is to close your trade in sections or pieces. An example would be if you had five buys on the stock that is falling and would have to sell the same five. This situation might occur if you are looking to scale down while a position is heading in a good direction, allowing for favorable trades. In order to close in pieces, you will need the stock to settle at its position and strong rallies so that the pieces are of equal proportion.
The other method would be to close the entire position all at once, which is done either when you reach your goal or if things have gone south. If you reach your target, exiting the whole position at once is best to benefit completely from the profits, even though it poses a higher risk. Alternatively, stop losses are highly useful and a safe bet, and sticking to them is most important when you’re in a bad position.
The use of averaging down is not the best strategy; it is more of a hopeful attempt at saving your trades than a profitable technique. If you decide to pursue it, be sure to monitor your positions carefully and average down from a strong position.