Thursday, March 24, 2011

Averaging

A reader have written to me:

"I see that a lot of former floor traders tend to average losing trades and therefore get stuck with huge paper losses during extended market moves. Is this a common strategy among floor traders?"

I believe this is a inherit human pyschology, inborn in us to react in such a manner that we are buying something cheaper now than what we have bought earlier, thus average to get a medium price.

Of course, the problem is when we buy cheaper and cheaper and even cheaper. Where is the bottom? How much more money we have to buy further? Futures trading is based on leverage, it even bankrupt Barring Bank when my fellow trader Nick Leeson average the Nikkei after the Kobe earthquake.

Most new traders adopt this strategy of averaging on bad trades basically because they don't know how to cut losses, unwilling to cut losses or cannot bear the pain of cutting losses until a level whereby it bust their account.

Most of the time when a trader averages on a bad trade, the market is kind enough to come back for them to take a small profit. They can do it for days or weeks but one hit will wipe them off for the past effort in accumulating the profit. How to make money in the long run when it's only small profits and huge losses?

Traders who adopt this strategy will not be able to make it because most of the time they will be back to square one from where they first started, it can be 3 months down the road or 2 years down the road, wasting their time, effort and money.

For those who failed as a trader, asked yourself honestly whether are you one of those who have adopted this strategy subconciously. Ask any trader who losses money on any particular day whether he averages on bad trades, most likely answer is yes.

Averaging on bad trades is a very bad habit meant only for those traders who have very very deep pocket and traders who have planned it together with strict money management rules. They might have to hold the rotten position for weeks or months suffering the agony of the paper losses and lost opportunities.

I do averaging at times when my discipline is down, most likely I'll lose money at the end of the day, strange? That's the fact. I have to justify why I average on a bad trade and ever ready to cut loss when the price move further against me because I'm damn bloody wrong for whatever reasons unknown to me.

15 comments:

coconut said...

actually average losses is just and logical without the implication on leverage. if one willing to buy at $5 then he should be happy to see it go to $4.

but i can immagine the floor trader carry huge level of leverage thus rander average losses extremely dangerous.

on longer term trading, one still can adopt this as long as you know and plan your total loss and honor your cut loss point. plus an all important plus you are able to average winner in case you are damn right in your first execution.

for position trading, one should learn both scale up and scale down on both ends.

thats my opinion.

Balasubramanian said...

Very true, I have been experiencing this issue for very long but now with "great traders" help, my averaging down days have been largely reduced and am working towards "nil"/month.

Whatever said in your posting, each n every word is true. I am a victim and STRONG supporter of NOT averaging down. Rather you take a loss and move further instead of sitting on a bad trade.

I have experienced in a positive way when you cut for whatever loss it is(ideally less), the lost money definetly comes back to you. So do not have to worry that I had a loss in a trade. This feeling is something great and once you start having this experience, you will never go back to average down. Also, have to keep telling ourselves that "I cut n move forward" rather than averging down. I had to adapt/try so many ways until I get rid of this. Even I called my broker house to implement cap on specified no. of open positions so that even I try the system does not allow.

For any newcomer who want to be successful in trading carrer, should NEVER think of averaging DOWN.

coconut said...

thats being said, i absolutely agree with what you say and i was once a trader always make some money and always end up where i started.

coconut said...

and a word for bala, please don't assume that any "bad strategy" will not make money.

no one strategy is perfect, you must learn when to use what, provided that you have learn to impliment those strategies.

is like saying you must learn to use both hands then when situation arise you can use either left or right at will and not get caught wrong "footed".

coconut said...

that being said, losing a great opportunity (opportunity loss) is as bad as any losses on "average losses".

Balasubramanian said...

I am an outright futures trader where the leverage is high, I have NOT seen any good of averaging down. It is always BAD.

Yes, but I do average down to buy stocks whenever there is a cheaper price and the fundamentals of the company is good, but here I am an investor and no leverage at all.

I believe, the writer too refers too futures trading...

coconut said...

that write is i believe fat haha.

i'm referring to all trading, not just stocks.

you can control the leverage and not let leverage control you. and a person who average losses are usually those who have guts, but ofcos guts alone can't make money.

Balasubramanian said...

For a newcomer, it is too difficult, (I am just being practical) - to control leverage..

Hence, to start with, my bottomline - NO averaging down.

You know, I have lot of guts - to average down all the way to margin call, net result burst account..few times...if you refer to my posting may be a year ago..you would find...

as said by FAT sometime ago, GUTS is to average up on a winning positon, not to average down..

Only when I stopped avarging down, I can see my acct building up..as the days goes..it builds up nicely as I start to average up..increasing size slowly

I meant writer who wrote to FAT

coconut said...

ok bala i agreed, average winning is difficult for me too and yes, learn to do it.

glade you have improve a lot.

su said...

I don't think averaging is wrong in general.

Obviously averaging down without risk management or any cut-loss idea is stupid. Averaging is basically trading as if you're long gamma when actually you're not since you don't own the option that saves your position when the averaging trades go against you, whether long or short. At the same time, every trader is always short a barrier at their max pain threshold, their margin call level, etc.

But determining when to average in and when to cut is the whole point of discretionary trading. New traders typically average in while they have no buying power, so of course averaging makes no sense. The probability that random noise will force them to exit their position is exceedingly large, even if their view is correct. Their % capital at risk tends to be the real problem.

I've seen traders add to winners and get blown out faster than you can blink. Just look at Volkswagen short squeeze and wonder who is paying the all-time highs. I'd much rather average a loser than add to a winner that is unsustainable.

The bigger problem is always a poor understanding on risk management, whether averaging down or trend-following.

coconut said...

su, i got short gold at 1436 and 1446 yesterday, tell me how to add if the gold go down from here?

datagram said...

When I was local, I started to average down and make good money. I felt so good. I started to tell myself “whoa, I’m such a good trader!” Until one day… I lost 1/3 of my account in 1 day by averaging down, then few days later, I lost again. So in less than 10 days, I lost 1/2 of my account. What a lesson!!! So yes, the most important thing is to understand money management but also to have a plan. You should know when to enter, when to exit or where to move your stop loss to protect some profit in case it's a runner and where is your stop loss. That's all. After? Just watch and wait. No stress, because you know that if it's a loser it doesn't matter because your strategy give you at the end an edge.
Most of time when it's a loser, it's a loser and there is nothing to do about it except to accept the loss you already accepted before entering the trade. So why stress for a loser and waste money, time and confidence for it? Ego? Just to show we always win? And of course, during the fight for the loser, we miss the runner!!! The one that give us back 4 or 5x our loss. So before averaging down, we should always remember our plan and leave the market to decide. For me, the fun part in trading is planning my trade, and see if it’s working or not, so I don’t want to lose time with losers.

Fat88Trader said...

I believe averaging down is for longer term traders because they have more time to decide and plan what to do with the lousy trade.

For short term traders, it is a no no because it might progress to become a long term trade, unplan for.

There were a few times I nearly went busted averaging down during my early trading days. I was known to many as a average king but I was lucky to survive.

Once my account was left with less than US$2k, literally can't even trade. During those early cowboy days where the rules were lax and many blur people around, I managed to write 10 lots of currency options with the premium of about US$5k credited to my account to use as margin for scalping.

The worst incident was when I shorted the currency all the way up to 35 contracts and dared not submit my trading cards to my broker. I was trembling, I didn't know how much I have lost, whether I have busted my account. Lucky the market came back down for me to recover the losses or else I won't be here.

Averaging down on leverage trade is dangerous, traders must be prepared for the worst case scenario using this strategy.

coconut said...

hahaha...

coconut said...

haha, don't misunderstand me, i'm laughing only at "average king".

beside knowing exectly where is the cut loss point is cos when you average, the losses tend to "explode" right in your face. the other important note is to average your winning if you are right in the trend.

you obviously do not want to risk averaging losses for say 5 contracts vs holding only 1 or 2 contracts when you are right.