Why averaging down is the WORST trading strategy

by , 08 August 2018
Why averaging down is the WORST trading strategy
Whenever I hear a trader uses the averaging down strategy, I cringe.

Averaging down for a trader means they'll buy more shares at a lower cost to drop the average price per share in the belief that ‘when' the share price rises they'll make more money.

The problem with this is when the share price keeps on falling, the trader stands to make a much bigger loss if it keeps moving against him.

You all saw this infamous 90% share price drop… *cough Steinhoff*.

So, a trader who used this strategy would have seen a huge chunk of their portfolio eaten away.

Here's why…

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How averaging down can turn a meagre 5% loss into a 15% loss to your portfolio
 
Let’s say you have a R50,000 portfolio and you decide to buy 500 shares at R50 per share.
 
You’re exposed to R25,000 worth of shares (500 shares X R50 per share). The stock decides to drop down to R40 per share.
 
Instead of cutting your R5,000 loss and moving on, you buy another 500 shares at R40 per share.
 
This lowers your average price per share to now R45. However, you’re now exposed to R45,000 worth of shares (1,000 shares X R45 per share).
 
The market then drops to R30, where you now get scared and take your loss. Instead of taking a R5,000 loss you end up losing R15,000 (30%) of your portfolio.
 
Three more trades using this costly strategy, and you’ll be bankrupt before you know it.
 
Don’t commit the two sins of trading by averaging down
 
A stop loss is an instruction you set for when a share moves against you and gets you out to prevent further losses.
 
Averaging down is a common trading strategy that newbie traders use to avoid taking a loss. They commit two sins of trading when they average down:
 
1. Marrying their stock
2. Denying they’re wrong
 
Money management rules are there for a reason, don’t let greed and ego take over.
   
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Is there ever a time when averaging down could work?
 
If you are an investor for the long term and you have done your thorough fundamental research on a company, then averaging down could work by accumulating shares in the future. But with trading it’s the opposite.
 
If you’re trading the stock market in the short term (one to three months per trade), averaging down is probably the worst trading strategy you can pursue. 
 
Always remember, “Wisdom yields Wealth” 
Timon Rossolimos,
Managing editor, Red Hot Storm Trader
 


Why averaging down is the WORST trading strategy
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