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The topic of cost averaging is one that will engage all of us at one point or another, from new traders to those still maturing to advanced and experienced veterans. The occasion to reflect on this presents itself via a text message that turned into a telephone call on the same day that I am writing this.
Readers will likely be aware that this March has thrown some surprises into many global markets across diverse assets. Inevitably, such price action creates a few winners but a lot more losers. Furthermore, a dysfunction of market personality will always put the spotlight on traders’ negative habits and traits.
The trader I am referring to was stuck in a losing position and called me because his market had suffered a few down days, and then the bottom seemed to fall out. Along the way, he elected to add to his position size. He asked me to consult with him regarding his trade management, wanting to know whether to close the trade, buy more and double down, or hold and/or hedge.
This conversation presents a chance to segue into the truths about cost averaging, otherwise known as “doubling down,” or technically, the Martingale strategy. The theory is that if one continues to add to a losing trade, eventually the market will turn. Of course, this would be more likely in a binary world; however, sometimes markets do turn but do not rebound quite enough. Therefore, to employ this strategy, the trader would need to continue to add heavily as the market goes against them.
Some traders have found this approach to have some short-term benefits. In fact, I knew one trader who enjoyed close to fifty winning trades in a row. The problem, however, is clear – that eventually, a market will not recover. Additionally, even when it does work out, it may require a lot of time, and mental, emotional, and financial capital to hold long enough for the trade to eventually turn favorable.
This aggressive strategy has been used in all kinds of betting because it is essentially gambling. It is not based on any technical or fundamental appeal but on statistics that suggest a market will eventually turn. However, statisticians also point out that this approach will eventually lead to ruin in gambling. I suggest that when applied to trading, the risk of ruin with this so-called strategy is realized much more quickly than at the casino.
First, before I consider more reasons why this approach leads to disaster, I want to clarify one proposal, perhaps dispelling a myth. Given the appropriate parameters, there is nothing wrong with adding to a trade. Again, let me be clear; if you want to add to trades, then the following rules are the best, and perhaps only ways, that it might work.
The initial key rule is to only add to a losing trade when you entered the trade at a portion of your regular size. This will involve having a standard size that you employ in your trading. When approaching a market with a plan, you might implement the trade in thirds – for example, buying one-third up front, then potentially adding the other portions later. The benefit is that because you are trading smaller, you are giving yourself an edge to potentially get a preferred entry.
Secondly, only add to losing trades when you have intentionally planned to add in stages before you entered the trade. If your plan involves incremental sizing, then you may be more likely to stick to your plan. However, if you add to the losing trade on a whim, you are doing it impulsively due to an emotional response. Emotional trading is a surefire way to lose over the long term. If you have not planned sizing into a trade from the beginning, then it’s best to avoid the practice.
The third appropriate way to add to losers is if you follow the same practice with winners. In other words, if you are willing to add to winners, enabling yourself greater size when the market goes in your direction, then you are used to managing market swings and positioning either for good short-term or long-term momentum trades. Perhaps it is best said this way: if you are uncomfortable adding to winners, then there is no way you should consider adding to losers.
The fourth factor to consider when adding to trades is your risk to reward. If you are mechanical at generally having a 2:1 return on risk, or even better yet, 5:1, then you have command and control of your positions. Therefore, this allows you to leg into some trades that don’t go your way because you will need fewer winners in order to make money.
The fifth criterion that you may use when assessing the appropriateness of adding to losing trades is whether you set a reasonable and responsible stop loss on the position and have the habit of not breaking such a rule. In this case, you have already determined how much heat you are willing to take on your position, having done so with a clear mental outlook before any emotional qualities entered your trade management horizons.
The sixth and final condition is to add to trades when the technical (and fundamental) momentum is not strongly against you. Getting caught on the wrong side of the trend is quite painful, and momentum tends to last longer than we sometimes think.
In short, adding may give you an edge when you approach the practice with responsible risk management, as in the rules listed above.
However, LET ME BE VERY CLEAR that without a solid plan, adding to trades creates the ability to blow up your account.
For example, when my friend called me looking to respond to a bad situation, I told him cost averaging was the worst thing to do. Why did I come to this conclusion? Because cost averaging to rescue a trade is an emotional decision that frequently makes things much worse.
In my friend’s case, he was caught on the wrong side of some sober market activity. It seems when people double down, they do so more by thinking about the “what if” the market turns and how they can quickly recapture their equity. However, few ask “what if” the market continues, even sharply, against your position. The losses quickly add up.
There are other factors to consider that I briefly mentioned in the introduction. First, cost averaging eats away your financial capital, resulting in your putting up margin while waiting for a market to turn potentially. All the while, you could be using that margin amount in a healthier trade, utilizing better rules. This goes along with the time value sacrifices; your money is held in one position, likely longer than you intended.
Moreover, the time value will weigh on you, giving you one more potential distraction in a busy world. The result is a sacrifice of mental capital. The longer that losing money and watching a poor trade lasts, the more it weighs on your intellectual abilities, requiring mental exertion disproportionate to what should be allocated for a single trade. Finally, this will inevitably weigh on your emotional health, and perhaps even physical health, because you may be hardly able to relax and may even be losing sleep at night.
If it seems that I know a great deal about this, it’s because I do. I have experienced this myself, and it’s why I’m concerned for my friend as well as my readers. The bottom line is if you can keep (and even add) to the rules I mentioned earlier, then adding to losing trades could work for you. However, if you struggle to keep rules and/or you trade emotionally, then cost averaging is not for you, at least not until you experience further vocational growth.
The preservation of capital is fundamental. So keep yourself safe and protected. Until next time, trade well!
