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.