How To Lose Everything – Use A Bad Trading Strategy

In the last few chapters we wrote about trading, we touched on the importance of back-testing your strategy and how this can help to identify both poorly performing and trading good systems. In this trading article, we discuss a trading strategy that has been touted around quite a bit but is probably the worst strategy you can use.

By showing you this trading strategy it is hoped that:

It should teach you what not to do ...
Encourage you to do the exact opposite

Unfortunately, for the beginner, this strategy seems quite logical but it is fundamentally flawed. Many people have become stuck in its claws and have lost substantial amounts of money because of its apparent logic. Do not be one of them!

The trading strategy is called averaging down. An example may help to illuminate how this works.

Averaging Down – An Example

Let us assume that you have just bought 1000 shares of stock XYZ for $50 a share. Your intention was that this stock should hit $100 in the next 6 months. You place a stop at $25.

About a month after you bought it, the price has declined a little and it is now trading at $40.

You then decide that you will buy more of the same company at $40 per share. As such, you place an order for your broker to buy 1000 shares at $40 each.

You now have 2000 shares altogether – 1000 shares bought at $40 and a further 1000 shares bought at $50.

In total, you have paid $90000 for 2000 shares ($40*10000 + $50 *10000) which make the average price you paid per share at $45 ($90000 / 2000).

You now have 2000 shares that are currently at $40 per share. The average price you paid for this is $45.

Let us now assume that the decline continues to $30. You then decide to purchase a further 1000 shares at $30 per share.

This means that you now have 3000 shares at a total cost of $120000. This makes the average price of each share you paid $40.

The above example can go on indefinitely, however, let us assume that you have had enough buying and eventually sell all your stock at $25 per share when you are stopped out.

The example above shows what averaging down means. It effectively means that you dilute the price you paid for each share by buying more shares at a lower price. The theory is that you pay a smaller amount per share and thus reduce your risk accordingly.

Let us now take two situations. The first situation is that you did not average down from the beginning and the second situation being that you did average down. How much would you lose in each situation?

Situation 1 – No Averaging Down

In the example above, you bought 1000 shares at $50. This cost you a total of $50000. When the price decreased to $25, you would have sold all your shares at $25000.

This means that you took a loss of $25000 to your account.

Situation 2 – Averaging Down

In the example above, you eventually bought 3000 shares at a total cost of $120000. You sold all of these shares at $25 releasing $75000.

This means that you took a loss of $45000 to your account.

In the example above, you took almost 80% more losses in averaging down than by not averaging down – and that is a very big hit to take. The trader in the example did not take into account the following:

You added to a losing position. Remember the old saying – “Follow the trend.” This means that you do not add to a position that is already losing as the share price will probably continue to go in the same direction!

You took on more and more risk. Remember that by adding to your trading position, you are increasing your risk and loss in that position if the trade starts to go against you (and it probably will)!

It is much better never to add to a losing position and never average down.

However, averaging up – that is to add to a winning trading position in a similar manner - is a winning trading system. By adding to a winning trading position you are effectively doing the opposite to averaging down. You are building more into a position that is already winning and therefore potentially magnifying your gains in your trading.

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Secrets Of A Trading Veteran? Simply Visit
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Nicolas Darvas
http://www.nicolasdarvas.org/
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