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.
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.
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