Trading Losses Can Come From Averaging Down
September 7th, 2010 | by admin |The area of trading money management is first and foremost supposed to help you get a grip on trading losses. Good policies are what you need to make sure that you don’t have to lose more than you can manage. Sadly though, some strategies are more destructive than helpful. One example of a dangerously counterproductive technique is averaging down.
Averaging down isn’t too technical to understand. The basic premise behind it is buying units of stocks that are already on downward movements. This is an obvious slap against logical thinking. Third party observers realize this immediately but traders who use this strategy simply don’t realize that they are on the wrong side of the road. They continue to average down because they see lower average costs. When they take a peek at their investment losses and profits, they spot only the cheaper average price per unit. This is where genuine analysis takes a back seat.
At this point, common sense should kick in. The strategy may push average cost down but this doesn’t mean you will start to see profits. On the contrary, continuing to buy units of a stock that just keeps on falling can only serve to magnify your losing streak.
There is a deeper explanation as to why traders stick to this strategy when it is obviously flawed. Those who continue to stubbornly apply it are in denial and are very desperate to recoup their stock losses. They can’t see the error of their ways because emotions have taken over. They are too far distressed that no amount of logical prodding can snap them back to their senses.
This is what makes addressing trading psychology important. Before traders even start trading, they should set the right mindset. The best psychological state to adopt is one that does not leave space for emotions to play. Decisions should be supported by facts and research. Moreover,
they should be guided by a strong trading system that has been back tested.
Taken as a whole, the parts of a trading system take charge of
limiting trading losses. One element that can address the tendency to average down is money management or risk control. When you’ve made the rules for money management, you’ve also effectively set the levels of risk that you are comfortable taking. You will therefore never have to live through losses that are too huge. To set your rules, you just have to identify your trading float, trade size, stops and maximum loss.
You can also incorporate averaging up into your risk management plan. This is clearly on the opposite end of the spectrum as averaging down. If averaging down is illogical though, you can expect its opposite to be logical. Averaging up can be a bit costly but it is still a good choice. This is because what you are doing is buying into an already profitable position.
It may not be easy for some traders to take the best path to cut their stock losses. This is especially when emotions are already part of their trading system. When temptation looms, firm risk management rules are the only points that can secure logical thinking.