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Averaging Down (Safely)

Posted By Robert On Thursday, December 12th, 2013 With 0 Comments

Many new spread bettors may be tempted to “double-up” their stake in a losing position on the basis that this will lower their average cost of ownership and will lower the price at which their combined position will “break even”. If you stake £1-per-point at a price of 100 and another £1-per-point at a lower price of 50 then – hey presto – the price only needs to recover to 75 in order for you to break even and close the bets.

Note that one of the problems with this strategy is that novice spread bettors have a tendency to breathe a sigh of relief and take back the cash as soon as they have broken even in this scenario. So in the best outcome they make no profit, and in the worst outcome the bets become worthless.

While a surprising number of traditional investment books advocate the “average down” strategy, most successful traders will agree that it is usually better simply to let the losers go while running the winners. At worst those losers could fall all the way to zero and take an increasing amount of your cash with them, and at best the losers are tying up cash that might be better deployed elsewhere.

In a longer-term position trading strategy rather than a quick-fire day trading strategy there may be some justification for holding onto falling stocks using small stake sizes, and there may even be some justification for “averaging down” on a losing position providing you do so safely. Which begs the question: “How do you average down safely?”

One answer to this question is to average down uniformly across a large number of diverse positions so that no one position becomes a magnet for your cash. If the price of stock “A” falls by half, and you average down, think about averaging down stock “B” when it halves in price before you think about averaging down stock “A” yet again.

Another answer to the question is to take on less additional risk each time you average down.

Suppose you establish a £1-per-point position on a low-price stock at just 20p-per-share, for a risk of £20. This volatile “penny stock” halves in price to just 10p-per-share, so an additional “averaged down” position at £1-per-point will add a lesser £10-worth of risk. When the price halves again to just 5p-per-share you can add yet another £1-per-point position for an additional risk of only £5.

The beauty of this approach is that it protects against a single losing position becoming a magnet for all of your cash, because: the more the price falls, the less additional risk capital you commit. Yet it is more cost-effective than (in this case) having committed the full £3-per-point at the outset.

Note that this approach to averaging down safely can be implemented on higher-price stocks, indices and commodities too if we think of it in terms of the risk-to-stop. A £1-per-point spread bet on the FTSE 100 index at 6000 with a tight stop order at 5980 risks £20, and when the index price falls to 5990 an additional £1-per-point bet with the same stop order at 5980 risks just £10, and so on in ever-decreasing amounts.

This is different from how a traditional investor might average down by making an equal-value investment – let’s say £1000 each time – whenever the stock halves in price, thereby doubling his capital-at-risk on the second go. It is also the opposite of what some novice speculators might be tempted to do, which is to invest increasingly higher amounts (god forbid) each time the price falls, in a desperate attempt to get back to “break even” even sooner. This is an example of a Martingale money management strategy that I’ll describe in the next section.

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