Tax Season is Here! Save 15% on H&R Block Online
iconAll times are GMT -4. The time now is 05:03 AM. | Search:

» StockRants Stock Forum » General Forums » Traders Lounge » Rants & Blather » The Case Against Averaging Down



Reply
 
Thread Tools Search this Thread
Old 06-03-2009, 02:04 AM   Nav to Top  #1
garyd
UberTrader
 
garyd's Avatar
 
Join Date: May 2009
Location: Seattle
Posts: 62
Favorites: HEB GNTA BDSI
Rep Power: 201
Reputation: 1800
garyd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant future
Default The Case Against Averaging Down

So here is my counterpoint to the practice of Averaging Down, which seems to be very popular among many members of this board and others. My opinion in a nutshell - if you are truly an active trader - most times it is a bad practice.

Now before you all flame me and ban me for being a heretic, consider the following - I am guilty of being a bad trader at times too. Mea culpa. Caught myself averaging down a time or two. But I'm trying real hard, Ringo, to be a shepherd and not a sheep.

Okay, here are the nuts and bolts of my argument that averaging down in a falling stock is a bad move for an active trader:

1) You are allocating a larger portion of your portfolio to a position that is not doing what you anticipated it would do before you bought it.
2) You are putting money in a stock whose fundamentals are now running counter to your trading strategy
3) You are tying up capital you could and should be putting in a stock that still has near-term upside potential
4) You are focusing on lowering your average loss per share rather than total portfolio gain

If you are like me, when you turn on your computer to see how your portfolio is doing, the first number you look at is likely your total balance. Next you might look at your daily gain/loss, then perhaps your funds available for trading, and lastly you probably look at your individual positions.

I believe this is a normal, healthy approach to your trading. You should be in this game to grow your total balance, not win every hand so you can gloat about a $100 gain that took you 3 years to realize.

This concept I'm about to expound on applies more to day traders rather than buy and hold investors. I think it is possible to be both, but you need to be truthful to yourself about why you are holding a particular stock. Consider this situation:

Trader Bob is following multiple biopharma stocks that have FDA reviews coming up in the next 3 months. After careful review he selects several horses to place his bets on; he decides his entry point and exit points, whether or not to add trailing stops, how long he plans on holding, and what portion of his portfolio he is willing to risk on these stocks. He is playing them long.

Stock #1, let's call it HEM, has an upcoming FDA review date about two weeks out. Bob decides he is comfortable betting 10% of his portfolio, which sits at an even $100k, on this stock. He buys 10,000 shares at $1.00 and decides not to set a stop on any of his FDA plays due to the high volatility.

Stock #2 is called ADIEU, it's FDA review date is about 12 days out but it's drug is not as hyped as HEM, so the volume is much less. Bob picks up 20,000 shares at $.50 for another 10% of his portfolio.

Stock #3 is called ANIS, has very low volume, and has never been able to get the FDA to approve one of its drugs. This would be a big coup for ANIS, even though the drug they are pumping has multiple competitors. Bob decides to buy anyway; he picks up 1,000 shares at nearly $10 per share.

Bob dutifully updated his trading to journal to reflect his optimism that these stocks will rise after receiving FDA approval, and that he would sell them shortly before the actual review date if the price doubled over his purchase price. If not, he was willing to let it ride until the review came back, good or bad. More importantly, Bob put careful consideration into how much of his portfolio he was willing to risk on these potential winners. After all, he was not betting on stocks that had little or no chance of approval; he already weeded those out in his due diligence.

So during the next few days leading up to the first announcement he avoids the temptation to add to his positions, despite all the hype he reads on the finance boards. He's comfortable with his allotment as he originally laid it out.

But then something happens. ANIS gets the dreaded FDA Complete Response letter that tells them their drug has killed 6 patients in Phase 3 trials and is no more effective at fighting toe jam than a bar of soap. ANIS's stock price plummets to $3.91 in about two minutes!

Bob panics - he glances at his account balance and sees it is down by $4,000 from what it was this morning - good thing his other stocks are taking up some of the slack! He looks at the individual total for ANIS and sees he is in the red over $6,000 on that stock alone - a 61% loss! He glances at his available funds for trading and sees that he wisely kept $30k in cash so he could jump on board a winner should one take off.

After doing some quick math he realizes that if he buys another 1,000 shares at 4.00 his average loss per share on ANIS will only be $3 instead of $6, and the 61% loss will reduce to 30%. OMG he types in to Google finance, this is a buying opportunity! And so he buys another thousand shares. Or two thousand if he wants his average per share loss to lower even further. I mean, this is a 60% off sale for crying out loud!

This, I believe, is the moment Bob's pride won the battle over his sanity, and he lost control of his ability to make rational, unemotional decisions.

Looking at Bob's total account balance, it still says he is down $4,000 on the day if ANIS closes near where he bought in again. The difference is he has less cash, but a larger position in ANIS. ANIS just received a nasty gram from the FDA, so there is no good news on the near horizon for them. Their shares are trading slightly lower than their 200 day MA, not a good buy signal for most traders.

The next day ANIS is trending lower as more investors vacate their positions. Bob's total balance is slightly lower, but ADIEU is expecting good news, so that should fix things. But those bastards at the FDA are out to get poor Bob, as we know, and so they tell ADIEU adios muthaf*&^er. After a quick 50% runup in price (that Bob dutifully ignored, as per plan), the news comes out that ADIEU's cancer drug is actually rat poison, and while it successfully takes the patient's mind off his painful tumor, it fails to meet the FDA's maximum dead patient threshold, thoughtfully set at 5 sick people per NDA.

Bam, as Cramer would say, their goes ADIEU's price down to $.08 per share. What do you think Bob does here? Yep, time to go on a falling stock shopping spree. He knocks his trading journal to the floor as his fingers fly over the keyboard, 'Fill those buy orders, dammit!'. When the dust settles, Bob has used all his available cash to buy up the "Ridiculously Cheap" shares of another biopharma with a bad rap sheet and at least 3 months of delays. His total account balance is now at $86k, as ADIEU's price did the proverbial dead cat bounce and settled at just 10 cents per. “But hey, my average loss is lower now!”

Now his remaining horse is HEM, as close to a sure thing as he has ever seen. In fact, if he had more oats he would feed that horse once the race got started. But alas, he has spent all his available cash averaging down on those other nags. I think you can see where this story goes now.

None of us knows whether HEM will take off or die in the chute, but we do know this: If it does go, Bob will be an instant winner in that race to the tune of $10k (assuming he follows his trading plan, which would be a first), and his account balance at the end of the day will be $98k if he closes his position in HEM after a 100% gain. So after a week of nerve-wracking stock watching, Bob's account balance is $2,000 less than it was before he instituted his plan, he has larger allocations in two stocks than he was originally comfortable with, and those two are proven dogs with no near-term potential.

So Bob, instead of being an active trader in the fast moving biopharma sector, has become a buy and hold investor who gets to sit on the sidelines and wonder what happened to his trading journal. Why? What happened? I'll tell you what happened, Bob let his pride get in the way of rational and prudent decision making. He refused to take a loss on a position. Someone on Google told him never to do that(and if it's on the internet it must be true).

What would have happened if Bob had stuck to his plan? Here is one possible outcome: He didn't average down, instead he held his original positions, albeit it at a loss. He then used his available capital to buy more of HEM after the FDA approval was received, and rode an upswing for additional profits. Under this plan Bob's total account balance would, at the very least, be equal to the version where he averages down, but assuming he was able to get more shares after approval of HEM, perhaps it could have added another $10k of a RISING stock, and now sit at $108k.

In another possible outcome he sold one or both of his losing positions in ANIS and ADIEU, and used that cash to buy more HEM. At worst he still has a $98k account balance, more in cash, but if he rides HEM with more shares maybe he gets an additional $10k. So his total account balance, the only one that matters to me, is now at $118k.

Now I realize this assumes a lot of variables, and even a best-case-scenario or two, but that is the nature of examples. You have to use something.

If you think I'm exaggerating a little, consider these real posts:

My ADLS was avg'ed in at .89 I believe and then I bought more this morning which, temporarily was a good move....now I'm avg'ed in at 1.04.

EPIC FAIL!

my only consolation is I'm up net 8k and change today.
sigh...just saw that on my TDA acct. Looks like I'm in this one for a bit longer...or at least until I can take a palatable loss.

boo ADLS...boo I say!
There was another post somewhere in the HEB thread I believe, where the poster was lamenting his inability to invest in HEB because he was averaged in with all his capital in two or three stocks with no near future. Why could he not sell those positions at the market price, play HEB for what he can, then buy back into those original stocks if he was so in love with them? He could likely get them at or near the same price if they had no pending news or products - technically he still hasn't "lost money" on them.

I've seen posts from other members urging people to 'hang on, never sell at a loss'. On Google one guy insisted that you only lose money when you close the failing position, as long as you hold it you haven't 'realized' the loss. That sounds like a semantics game, something the Enron accountants would say. I say it is a missed opportunity to put your remaining cash in something with a nearer upside.

I'll close this rant off by saying that I'm sure there are very valid circumstances when averaging down makes sense. But you must be honest with yourself and ask the question, 'Is this likely to make me the most money near term, or is my pride effin' with me?'

Looking forward to some thoughtful responses. Happy trading all.

GaryD
__________________
We have an old saying in Texas:
"I may have been born yesterday, but it wasn't yesterday night!"
garyd is offline   Rate this post Yes | No Reply With Quote
Old 06-03-2009, 02:51 AM   Nav to Top  #2
chuckd
UberTrader
 
chuckd's Avatar
 
Join Date: Apr 2009
Location: conyers,
Posts: 700
Favorites: KFN LVS NTE
Rep Power: 373
Reputation: 5419
chuckd has a reputation beyond reputechuckd has a reputation beyond reputechuckd has a reputation beyond reputechuckd has a reputation beyond reputechuckd has a reputation beyond reputechuckd has a reputation beyond reputechuckd has a reputation beyond reputechuckd has a reputation beyond reputechuckd has a reputation beyond reputechuckd has a reputation beyond reputechuckd has a reputation beyond repute
Default

Garyd, Its 2:37 AM and I am tired so I will make this brief.

First of all, kudo's for the "Pulp Fiction" reference. One of my favorite movies

As to your four points:

"1) You are allocating a larger portion of your portfolio to a position that is not doing what you anticipated it would do before you bought it."

I only buy in to a position with half of what I am prepared to spend.

"2) You are putting money in a stock whose fundamentals are now running counter to your trading strategy"

Just because the price per share is down, does not mean that the fundamentals have changed.


"3) You are tying up capital you could and should be putting in a stock that still has near-term upside potential"

Again I only buy half of what I am prepared to spend, and I am very rarely fully invested.


"4) You are focusing on lowering your average loss per share rather than total portfolio gain


When averaging down, I am not lowering my average "loss" per share, rather just lowering my average "cost" per share by using the money that I set aside when I first bought.


As for the rest of your story, by your own admission you include many "variables" and "best-case-scenarios" so to try and respond or counter argue seems pointless to me.

Finally "Bob" does not appear to be very smart buying only speculative bio-techs.

I look forward to reading other responses on this topic.

Cheers
__________________
All advice from me is guaranteed to be worth at least what you paid for it, or double your money back. All persons dealing with matters of personal finance are advised to gather information from blogs, books, radio and TV, consult with professionals, discuss the matter with anybody who will listen, and then make their own decision.
chuckd is offline   Rate this post Yes | No Reply With Quote
Old 06-03-2009, 10:15 AM   Nav to Top  #3
garyd
UberTrader
 
garyd's Avatar
 
Join Date: May 2009
Location: Seattle
Posts: 62
Favorites: HEB GNTA BDSI
Rep Power: 201
Reputation: 1800
garyd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant future
Thread Starter
Default

Chuck

Thanks for the insight, amigo. 'Buying in with half of what you are prepared to spend' - that is one of the smarter ideas I've heard, and it's the first time I've heard it. Your approach accounts for a possible pullback and lets you buy in again IF the opportunity presents.

How do you feel about buying back in after the bad news kills the near-term upside? Seems to me that money could be used more profitably elsewhere.

I've heard plenty of arguments in favor of averaging down, and lowering the cost basis is the favorite. But after the stock walks off a cliff I have a tough time understanding the enthusiasm and optimism necessary to reinvest.

I guess that's my short-timers perspective. Good comments Chuck.

GD
__________________
We have an old saying in Texas:
"I may have been born yesterday, but it wasn't yesterday night!"

Last edited by garyd; 06-03-2009 at 10:16 AM.. Reason: typo
garyd is offline   Rate this post Yes | No Reply With Quote
Old 06-03-2009, 06:05 PM   Nav to Top  #4
Mac
UberTrader
 
Mac's Avatar
 
Join Date: Apr 2009
Location: Nowhere, Land
Posts: 250
Rep Power: 295
Reputation: 3940
Mac has a reputation beyond reputeMac has a reputation beyond reputeMac has a reputation beyond reputeMac has a reputation beyond reputeMac has a reputation beyond reputeMac has a reputation beyond reputeMac has a reputation beyond reputeMac has a reputation beyond reputeMac has a reputation beyond reputeMac has a reputation beyond reputeMac has a reputation beyond repute
Default I'm doubling down!

GaryD; Thanks for your thoughts, and for such an eloquent post....your perspective is very good, and as you said, well suited for an active trader.

I, for one, am guilty of averaging down on almost every position I currently hold. First, I only use a small portion of my total buying power towards highly speculative plays. Most of my portfolio is populated by solid companies that I intend to hold for a long time, and my initial buy point is calculated to be a discount. When I see an irrational price movement to the south, that screams "buy opportunity" to me. ( If it's a discount at X, it's a deep discount at X - 15% and so on.)

Keeping cash in reserve in case the "opportunity" to buy lower presents itself is a strategy that has served me very well. After all, cash is king.

Of course, you're right, that the same capital spent averaging down may very well be put to better use elsewhere in a stock/sector with a rising trend, but my ability to time the markets sucks, and my time available for DD is uber-limited by my dayjob...so I mostly buy companies that I want to hold long, and lowering my cost average is the best (and simplest/lowest maintenance) method I've got to secure extra market share. My strategy won't win any awards, but it should make my retirement comfortable.

That said, don't EVER average down on a 3X leveraged ETF for pity's sake. ( I am speaking from painful, gut-wrenching, ass-bleeding experience)
__________________
-Mac

p.s. remember, it can always go lower, unless it's already at zero.
Mac is offline   Rate this post Yes | No Reply With Quote
Old 06-03-2009, 06:30 PM   Nav to Top  #5
AdamJ
UberTrader
 
AdamJ's Avatar
 
Join Date: Apr 2009
Location: Waterloo
Posts: 227
Favorites: OPC WTN GCE IAE QEC ITX
Rep Power: 211
Reputation: 1869
AdamJ has a brilliant futureAdamJ has a brilliant futureAdamJ has a brilliant futureAdamJ has a brilliant futureAdamJ has a brilliant futureAdamJ has a brilliant futureAdamJ has a brilliant futureAdamJ has a brilliant futureAdamJ has a brilliant futureAdamJ has a brilliant futureAdamJ has a brilliant future
Default

Good thought provoking post. Your argument can also be applied to averaging up. This week was the first an only time I've ever done that despite every fibre in my brain telling me not to the "what if" emotion won out. This is where applying scale trading methods are really key.

I've successfully used averaging down in day trading more so than anywhere else. Since I tend to look for undervalued stocks or stocks with some form of trend becoming clear my plays for the most part have been simple entry and exit points and DCA usually erodes my gains in those situations.

I think your argument has merit essentially not in challenging DCA but, in challenging the beast that gets almost every investor at some point and that is emotions. If you know the stock you've invested in and understand it's potential (or lack of) in the market than applying DCA can be very beneficial.
AdamJ is offline   Rate this post Yes | No Reply With Quote
Old 06-03-2009, 08:31 PM   Nav to Top  #6
Kordoyn
UberTrader
 
Kordoyn's Avatar
 
Join Date: May 2009
Location: TOronto
Posts: 383
Favorites: DOW TCK HEB
Rep Power: 280
Reputation: 3456
Kordoyn has a reputation beyond reputeKordoyn has a reputation beyond reputeKordoyn has a reputation beyond reputeKordoyn has a reputation beyond reputeKordoyn has a reputation beyond reputeKordoyn has a reputation beyond reputeKordoyn has a reputation beyond reputeKordoyn has a reputation beyond reputeKordoyn has a reputation beyond reputeKordoyn has a reputation beyond reputeKordoyn has a reputation beyond repute
Default

As with most trading strategies there is a place and time to execute them. Averaging down has merit in certain situations, even if it isn't the be all - end all of trading. There are many bumps and blips along the road from initial purchase to eventual exit in stock trading. Playing with the average down or up strategy can be an effective method to maximize profits, and that's what we are here for.

Take for example the graph of UUU.TO

I like to buy stocks on bad news, because I know that the market over reacts whenever there is a sharp drop, or a sharp increase. Buying on bad news makes it possible to get good stocks on the cheap as panic selling runs wild.
So you hear the news that UUU is having legal trouble, but you (because you did you DD) think that once this passes the stock will go up to its previous trading levels.

So you make your initial purchase at 50% discount, of course this should never be a full purchase with all the money you have set aside to invest in UUU. It's just what I call a placeholder entry, where you own a stake just in case the situation resolves itself before you can react. You want your foot in the door so to speak.
Next you watch, and wait. You see the price is still going down as people still continue to bail. Since it's virtually impossible to pin in advance the lowest point that the stock will hit, you make several purchases on the way down to 'average down'.

The fundamentals of the company have not changed but you missed the bottom on your first purchase (highly likely this will happen) Then with your next purchases you hopefully got closer to the bottom and into a better position for the rebound.
Kordoyn is offline   Rate this post Yes | No Reply With Quote
Old 06-09-2009, 06:00 PM   Nav to Top  #7
AndyB
Pro Charting Wannabe
 
AndyB's Avatar
 
Join Date: Apr 2009
Location: Manchester
Posts: 386
Favorites: $SPX GGG.L ARSLF
Rep Power: 321
Reputation: 4467
AndyB has a reputation beyond reputeAndyB has a reputation beyond reputeAndyB has a reputation beyond reputeAndyB has a reputation beyond reputeAndyB has a reputation beyond reputeAndyB has a reputation beyond reputeAndyB has a reputation beyond reputeAndyB has a reputation beyond reputeAndyB has a reputation beyond reputeAndyB has a reputation beyond reputeAndyB has a reputation beyond repute
Default

Agree 100%. Averaging down is almost always a bad idea. If you got your entry wrong, get out!

the only time I would advocate averaging down is when a stock is fundamentally extremely undervalued. But even then, averaging up is safer and has a higher risk:reward.

Here, these articles (posted elsewhere) shed some light on this

Scale trading
Invest-FAQ: Five Minute Investing: Chapter 6

Reverse scale trading
Invest-FAQ: Five Minute Investing: Chapter 7
__________________
I am a junior investor/trader with less than a years experience, so weight my words accordingly.

I'm using a stoploss at my break-even on SFEG. Production is delayed.
AndyB is offline   Rate this post Yes | No Reply With Quote
Old 06-09-2009, 06:52 PM   Nav to Top  #8
piccooar
UberTrader
 
piccooar's Avatar
 
Join Date: May 2009
Location: Fort Lauderdale, FL
Posts: 150
Favorites: BIPH, CTIC, HEB
Rep Power: 201
Reputation: 1688
piccooar has a brilliant futurepiccooar has a brilliant futurepiccooar has a brilliant futurepiccooar has a brilliant futurepiccooar has a brilliant futurepiccooar has a brilliant futurepiccooar has a brilliant futurepiccooar has a brilliant futurepiccooar has a brilliant futurepiccooar has a brilliant futurepiccooar has a brilliant future
Send a message via Yahoo to piccooar
Default

Two things to me, however, are indisputable: firstly, underlying business trend is more important than price trend: a rising price often might indicate improving business fundamentals and hence giving weight to the averaging up argument; while long-term investors are not wrong either if they choose to buy more at lower prices if they think business fundamentals have not weakened. I think that buying 1/2 or a portion of what you are ultimately considering is useful as a risk control tactic and provides the individual with the monetary means to take advantage of further price or business fundamentals developments.
__________________
Sometimes you're flush and sometimes you're bust, and when you're up, it's never as good as it seems, and when you're down, you never think you'll be up again, BUT life goes on.
piccooar is offline   Rate this post Yes | No Reply With Quote
Old 06-09-2009, 09:20 PM   Nav to Top  #9
garyd
UberTrader
 
garyd's Avatar
 
Join Date: May 2009
Location: Seattle
Posts: 62
Favorites: HEB GNTA BDSI
Rep Power: 201
Reputation: 1800
garyd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant futuregaryd has a brilliant future
Thread Starter
Default

I like the discipline I'm reading here, especially about your first entry being 50% of what you intend to eventually invest. Also buying the beat up stocks of good companies, I can't begin to tell you how profitable that's been for me.

I don't like seeing red numbers in my portfolio any more than the next guy or girl, but I refuse to sit on them until they turn green just so I can brag about my stock picking prowess.

If the news or fundamentals surrounding a stock do not favor a turnaround, I view holding it as a lost opportunity to make a profit elsewhere.

One tactic I'm practicing, I call it 'Not Seeing Red', is arranging my portfolio watchlist in TDA so that I don't see my net gain/loss in a position, I see how much capital the position is tying up instead. I monitor it's daily movement to determine whether it's grown stale, then decide if I have better use for that money. I'm not advocating this quite yet as a guru method, I'm just trying to find ways to remove emotion from my trading. As long as I don't lose sight of my profit/sell target, Not Seeing Red may be an effective way to do that.

That said, I'm still checking in on HEB news eight times a day, so I'm no Trading Terminator just yet.
__________________
We have an old saying in Texas:
"I may have been born yesterday, but it wasn't yesterday night!"
garyd is offline   Rate this post Yes | No Reply With Quote
Reply

Similar Threads
Thread Thread Starter Forum Replies Last Post
HUN - Huntsman Defeats Six Bank Motions In Fraud Case Stealpulse Rumors & News 13 06-09-2009 01:54 PM


Thread Tools Search this Thread
Search this Thread:

Advanced Search

Posting Rules
You may not post new threads
You may not post replies
You may not post attachments
You may not edit your posts

BB code is On
Smilies are On
[IMG] code is On
HTML code is On