Averaging Down - Is It Really That Bad?

The most quoted saying in the trading world is: "Never add to a losing position" and my favorite: "Losers average losers". But is this really true? Does this work in real life? Well that is what we are now trying to find out.

The rule of demand and supply determines the upps and downs in the market. It is very unusual to have price to trend in a very smooth and clean way for a long time. Most of the time the volatility is so great that it causes uninitiated trader's stop losses to get hit prematurely.

Let's now start with a simple comparison of averaging down v averaging up. I will be using as an example Citigroup (C) and Acme Packet (APKT) versus Apple (AAPL) to demonstrate the power of averaging down. A new position is added as soon as the price has dropped 30%. In the case of averaging up new positions are added as the price advances by 10%. I will be using normal share prices instead of currencies because the differences can be seen more clearly when using share prices.

Here are links to C, APKT, AAPL

Now let's assume the worst case scenario that we have started buying C at 55$ in mid 2007 and APKT at 20$ in early 2007 meaning that we bought at the highest price possible. Ok, so now we are simply just buying all the way down. The calculations can be found in the spreadsheet.

So looking at the calculations we see that the average price for C is 4,47$ and for APKT 3,1$. C is trading now around 4.7$ and APKT has skyrocketed to 53$. We would have made profit with C 559$ even though the share has plummeted! With APKT it's totally different. We would have made over 145000$. That's pretty impressing I have to say. The most interesting part is that with the profit made with APKT our capital is able to stand numerous cases where the share price would have gone to zero. This is the main risk with averaging down but the main fact is that no one can ever predict the price behavior so we just have to live with this uncertainty. This is called risk! And without risk there is nothing to gain. Risk and return go hand in hand.

Ok, but what about AAPL then? This share has acted like a dream and gone straight up, from 200$ to 320$ in less than a year. AAPL has been a trader's wet dream. Now, you all know that this kind of share performance is extremely rare, but I took it just for comparison. So if we had started averaging up our positions in APPL as the price was making higher highs, the average price would have been 250$. This would mean a profit of only 1710$!

If we are looking at the simplified ROIs we can see clearly see a difference in here: averaging down beat averaging up. When we buying at ever higher prices the probability of a reversal just gets bigger and bigger and when it happens it is usually quite strong and fast. When this happens there is no way of knowing will the price bounce back or is this the end of the line. With averaging down the situation is different, the probability for a bounce increases. Of course the most dangerous part is to run out of capital in averaging down.

Now the next thing you are thinking is that Forex and Equities are different. Well, you are right. But only to some extent. The price behavior is still the same. The law of supply and demand still holds - strong trends are rare and short-lived, they are hard to catch.

The idea of thread is to deliver conversation around these methods. Is averaging down a doomed method? The main saying when it comes to averaging down is that "It works 99% of the time but when it fails all your trading capital is lost". This is true to some extent, but with my several years of trading experience I still not have found an edge - it is too much work. I will not be going into details why I have failed/why it is almost impossible for a private trader to deliver and maintain an edge in this thread.

But my conclusion: averaging down works if it's used properly.

You can start shooting me now.

Hi everyone

I Think its true
i also think the Canadian dollar and the Australian dollar will rise due to the rise of commodities

No, Equities and Forex are not different to some extent, they are VERY DIFFERENT. The leverage factor in forex won't allow you to survive an average like the one you mentioned. You will have to have deep pockets to average in equities and of course in forex, you will get a lot of margin calls when you average.

The fact that stocks can't go below zero helps your averaging down, because you know there is always a floor. In forex, there is no floor, the pair can trend for years in any direction.

Have you tried to run the test for APPL but on the opposite direction? i.e. Short AAPL and averaging up (Against your position I mean). Try it and see how it can hurt (Because there is no limit as to how much the stock can really go up).

Averaging is not always bad, but it has to be part of your entry strategy. For example, you might know beforehand the overall required position size, but you decide to slice it up in chunks as the price goes down. But once you are fully in the position, you stop buying, or in other words, you stop throwing good money after bad.

If C or APKT went bust, you would have lost all the capital you invested + the time you kept averaging it down. It takes only 1 mistake to ruin everything.


Regards,

Nader

Or is it the opposite That commodities might rise because of the appreciation of the Canadian Dollar and the Australian Dollar?

Or is it another thing, that commodities might continue to appreciate because of weakness in the USD?

Or is it another thing, Canadian Dollar and Australian Dollar might continue to appreciate because of USD weakness across the board?


Regards,

Nader

Leverage is a deadly weapon, a true double-edged sword. It can make you instantly rich or poor. The latter being reality. There is a saying that leverage kills and this I can totally identify.

Averaging down in Forex requires that you do not use leverage and you need to cautiously calculate how many positions you are going to add and at what price levels so that you won't get a margin call. But my advise: Don't use leverage! It kills because of simple geometrics: (no leverage) 0.99*1.01=0.9999 (with leverage) 0.9*1.1=0.99



Pairs and stocks always trend, but they are hardly clear. Using basic moving averages or highest highs will destroy your capital. My point is that there are always reversals even in the strongest trends and it's impossible to know if the trend is ending or just taking a breather.


Averaging down does not work in short side because there is no limit how high a stock can go. In Forex this does not work completely like that because there is always a counter pair. E.g. EUR/USD pair can't go all the way to 10 because that would mean economical crisis for EURO. Of course this can happen but it's not a likely scenarion. ECB would interfere.


Higher return comes with higher risk. This risk always prevails but averaging down even 1 turn-around company will bring you massive profits so that your trading capital is able to withstand several bankruptcies. Averaging down is dangerous if you don't know what you are doing. First you must have a predetermined entry plan for every averaging position and you need to have dozens of different positions. And finally you must know the fundamentals as well. All in all the risk has to be clearly determined.

But in all my trading years (5+) I have not been able to find a constant edge. The markets change and market anomalies (read: profit opportunities) disappear very quickly. Averaging down has been the only method that has shown constant profit in the long term. I have tested countless of times averaging up equipped with basic stop losses and position sizing in Forex but all those attempts have ended up ruining my capital. Averaging up works only in strong trending markets, otherwise it's a recipe for doom.

Averaging down works if the pair is ranging such as EurChf, or flexible major usd pair such as eurusd
..and u spread the risk to many trades...with a good moneymanagement, and good EA, and patient

- buy when the price is going down 30 pips
-buy again when it goes down 30 pips
- do this again and again with a maximum 30 order
i trade last year with this method...
5000$ (5 pair) , 0.01 lot per transaction
i get a consistent profit of 8% monthly for 9 months straight

just remember to always close trades that already gain profit 50 pips
the key is always clear all transaction when u reached 30-40% profit (ussually happens 3-4 months)

No but you need to be ABSOLUTELY confident that the price will be going up and going up SOON and this temperature south-travelling of PA is just temporary and will pass in a relatively short time, otherwise it will eat away a large chunk of your account balance and you will be still stuck with a huge amount of unprofitable long positions that you would still need to spend an even larger amount of capital to close them if the price goes further down because remember there is NO Uptick rule like in stock market that can be triggered when the price falls too low so when the price falls, it just free falls until it decides somehow it's fallen enough and stops and that could take a LONG, LONG time, long after your account is blown.

Remember the #1 Golden rule in daytrading: Stop the loss quickly and let the profits run!!

You need to think both in terms of return and risk.

Return considerations:
With regard to timing entries, averaging down can arguably be helpful if you're uncertain as to how far price will retrace. However (if the position sizes are equal) all you're effectively doing is entering at an average price. Hence mathematically, over a large enough number of trades, you'll smooth your income, without altering overall expectancy. Smoothing, rather than maximizing, returns can be important if trading is your primary form of income, which you use to pay regular household bills.

Risk considerations:
To state the obvious: adding to losses can be dangerous if it is done based on a whim rather than according to a predetermined plan, or if the maximum risk per trade group is not capped, leading to potentially unlimited loss. It's also important to understand that, with a greater number of positions, your position sizes will be inconsistent, leading to the possibility that one trade group that goes badly wrong can undo the profit made by several smaller winning groups, possibly flushing several prior days' or weeks' worth of hard work down the toilet.

According to br0kers, one of the most frequent causes of blown retail accounts is excessive use of leverage in an attempt to recover recent losses. All of which brings to mind the famous Paul Tudor Jones picture:

No. Averaging down can be very successfully applied to a mean reversion strategy. For example, if price strays away from it's average price over a given period, many mean reversion strategies apply a form of scaling into a position through an averaging technique to catch the mean reversion. Obviously the degree to which averaging down applies needs to be managed as the technique itself of building a position from adverse price moves progressively builds risk in holding the position if price continues to move in the adverse direction.

If you never apply a limit to your averaging down you start to enter the territory of extreme negatively skewed strategies which during periods of long duration adverse price moves can significantly deteriorate your trade capital base in an adverse situation. A negatively skewed strategy offers lots of small wins and the occassional big loss. The more you stray towards the end spectrum of negative skew towards martingale variants, you approach potentially the mother of all losses, so be aware of this symptom of negative skew.

Most convergent strategies (and most of the strategies that retail traders apply) are negatively skewed as they typically offer higher win rates but lower reward:risk ratios. These type of strategies tend to give a false sense of safety in the market with the trader who applies them believing that the strategy is safe. The reason for this feeling of safety is that during normal market conditions where price favours reverting to the mean, this occurs much more frequently that the converse situation where price under momentum undertakes considerably periods of trending.

Mean reverting strategies that utilise averaging down apply the principle of attempting to 'catch a falling knife'. As a result they continue to average down under the assumption that price will 'eventually' mean revert and most of the time, they will be right. Unfortunately with all negatively skewed strategies it is the infrequent occurrence of non-random uni-directional price movement (eg. on a news event) or a period of market panic where these strategies can be crippled and big losses are incurred. Frequently these losses wipe out a trader or a fund. Note however that you can apply mean reversion without attempting to catch the falling knife. Personally I apply this to mean reversion strategies, but it is harder to find suitable strategies with this constraint that offer an edge over the long term. This is because over the long term markets rarely stay too long in mean reversion state. For example prior to 2002 for approximately 30 years or so, mean reversion would have eaten you alive. It is only since 2010 after the GFC that mean reversion has been a prominent feature of the markets.

Look up the fund LTCM to see what I mean.



In the world of negatively skewed strategies we have a spectrum of trading strategies from single trade mean reversion techniques to averaging down and ultimately to martingale type strategies. They have their place in certain market conditions but provide grievous pain in other market conditions.

If you apply averaging down to your strategy then it's best to test the strategy over the long term under as many market conditions as you can muster. They are appropriate some of the time but not all of the time. It's up to you to figure out when these times are. It is only by doing this that you see that it is not a safe strategy and can turn very nasty very quickly and before you are in a position to do anything about it.

On the other hand, long term success under positive skew is a different kettle of fish, but most retail traders aren't prepared to venture down this path as it is contrary to human nature....eg. to cut losses short and let profits run.

Averaging down if is a part of your plan and is controled by your MM, helps to optimizing your entry... averaging down blindly just becose is going down against you is simple madness

I agree with what being said. If averaging is part of a plan and made with no leverage there is no probleme.

Copernicus,

Not sure if you've seen this, but your mention of LTCM brought it back to my mind. I thought that it might be of interest to you. Soultrader was widely respected when he used to contribute here at FF.

I find his conclusions interesting:
"The lesson here and my message to you is that no matter how much you test, no matter how far you go back there will always be a market condition that your test does not have.
....
System designers need to add one more thing into their arsenal. They ask these questions when designing a system
1. When to enter a trade
2. How much to trade
3. Where to place a stop
4. Where to exit a trade

they are missing part 5 and part 6
5. How to identify when the market conditions cause the system to fail.
6. What to do when it's failed.
....
My advice to you is that when you design a system make it a system based on a solid market principle. and don't limit yourself - if it's good it will work on ANY currency pair."

However, if I understand correctly, their testing and live run collectively comprised 40 months of consistent profit, then it all collapsed within 4 months. This tells me that either they sized their positions larger, and/or took a larger frequency of trades, while their system was losing money during those final 4 months. My suspicions were confirmed somewhat when I read this:
"the bigger the drawdown the better the system works - thats because of a very clever money management strategy which i cannot reveal."

So how do you accelerate recovery during periods of drawdown? Either better entries/exits (which begs the question: why wouldn't you be using optimal entries/exits all the time?); by increasing position sizes, which is a double edged sword; or by taking more setups (again, if these setups lead to +EV trades, then why wouldn't you be taking them all the time?).

This confirms what I've read elsewhere about conservative and consistent position sizing being crucial. If anything, a trader should be more willing to increase risk while his system is winning (indicating that conditions are currently favorable), and to decrease risk -- ideally to zero by sitting on his hands -- when conditions are not. Recency bias, that leads to increasing risk to recover losses, is a fatal condition.

David
_________________________
[EDIT] Footnote: your comments about having different strategies for trending markets, mean reversion, etc reminded me of some research that I conducted many years ago, and posted a summary of the results here.

Hi H :-)

That was a great read. Sage advise from Soultrader. Points 5 and 6 that were highlighted are essential system design considerations. Couldn't agree more.

I had a read of 'When Genius Failed' by Roger Lowenstein who investigated the rise and fall of LTCM. They appeared to have abandoned their traditional arbitrage hedging strategy and bond spread arbitrage strategy (that was the bread and butter component of their portfolio) as liquidity dried up with their massive growth and then went full steam ahead into very high leveraged equity vol strategies (mean reversion) using options. They became massively exposed (despite the number of Nobel prizes in their ranks) as their models assumed the principles of Modern Portfolio Theory and failed to take account of the fat tails.

I really like your more conservative approach H and appreciate the warnings you bring in your posts. It is definitely warranted.Unless you really know what you are doing, this market has the amazing ability to sniff your exposure out.

I also definitely agree that history can never fully prepare you for the future and that your worst drawdown always lies in the future, but understanding how your system/s stack up against past market conditions, at least gives you a few clues to help you make your strategy more robust for the future.

PS. I was listening also to a few notable CTA's (eg. Bill Dreiss) who insisted that having a large drawdown in your strategy is a signature that you have release valves in place to blow of intrinsic risk steam. Straight line equity curves are a red flag to a bull for the risk management nazi's out there. Extracts of interest from Bill Dreiss are below.









"

yeah, I traded a mean reversion strategy; used a special standard deviation on the 'ol Bollingers, over layered with some Keltners. I made consistent profits and was test driving salubrious European cars. It worked like a dream for months.

But what do you suppose is your expectancy? Subconsciously, you know the answer to this. So eventually, when it happens, you're not totally surprised.

I don't care for your arguments, and I don't care if you choose to trade this way. that is part of the fantasy of trading. I'll always remember you seven series..

Yes it's work if you know what you are doing

Bollinger is many people's favorite because it seems to apply basic yet critical concept in statistics; however, it is not---Mr. Bollinger really failed to understand what normal distribution is all about.

Regards,

Average down - if you look past, like EURUSD 2 years from now - it is a gold mine, the pair hasn´t moved or trended for years.
And many other pairs stucked for a long.

So sometimes it is not bad, trend traders loose their under wear. And sometimes it is bad, look 2008 till now on EURUSD - deep pockets and low leverage might have worked. Same as martingale.

In FX - no correct answers. Being correct today = being wrong tomorrow.

Averaging is great. Do daily withdrawals and care not when it does not work. You will always win more than you will lose on the D-day...

And yet, watch out this term: statistical significance or just THE sample size ;-）

If you check out the default value of "Period" for Bollinger in MT4--it is 20. Seriously? ;-)

====================

His fallacious understanding of this basic concept is more fallacious than you think :-)

winners average winners

the quote is completly corrolated w/ the trader behaviour and experience