One of the more difficult things for a trader, and people in general, is to accept that they are wrong. We all have an ego and believe that our thought process is inherently correct. Unfortunately for traders, regardless of how much analysis, chart work and other research you do, the market can make it very expensive if you are both wrong and stubborn.
Averaging down is a trading concept based on a strategy of lowering your overall cost basis for a stock by adding to a position that is going against you. As an example, let’s say you purchase 1000 shares of stock XYZ for $50. The stock trades down to $45 and you average down by buying another 1000 shares at that price, thereby taking your 2000 share purchase down to an average price of $47.50. The good news is you only need the stock to rally $2.50 to get back to even. The bad news is the likelihood of that happening is fairly low.
Now you’ve taken an initial trade of $50,000 and turned it into a $100,000 trade with double the risk exposure. And you’re also adding to a position of a stock that is clearly not doing what you had expected. Before adding to a position and averaging down, ask yourself this basic question that can help you possibly avoid putting yourself at greater risk for losses…If I was flat and had no position in this stock, would this be a place where I would be looking to buy? My guess is with the stock dropping 10% from the initial purchase price and acting as you thought is should the answer would be no. There’s always a chance that there is support on the chart or another reason why you think adding to the position is the right play. But more often than not a trader is just trying to convince himself that there are justifiable reasons to not accept the loss and hope that the stock rebounds. As Jim Cramer said, “remember, we don’t care where a stock has been, we care where it is going, and it is most likely headed down if you are hoping.” While adding to a losing position may occasionally work, the best thing to do is stick to your stop price, cut your losses and clear your head for the next trading opportunity.