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In Jack Schwager's popular book
Market Wizards, a compilation of interviews with top traders, a common
theme runs throughout nearly every interview: that much of what is
successful trading is attributed to good Risk Management. Anyone
who has traded would know this to be true. In fact, we can even go
so far as to say that the proper management of Risks is the
difference between success and failure, no matter what system or
style is employed. Those of you who have survived many years,
actively participating in the markets will know this to be true as
well. Our success or failure as traders is defined by the day, and
since we are trading a market that is constantly in motion, the
constant management of our exposure to the risks that come with
these motions through time is what ultimately determines our
survival. As time goes forward, our trading styles and technical
strategies will change as dictated by the market's trends and our
own experience, but the proper Risk management system can be
applied from the beginning all the way through to the end.
The topic of Risk Management covers a very
wide array of sub-topics. And while we don't have room to discuss
it all at once in this week's article, we will focus on a very
common Risk Management "sin" among traders: Averaging-Down.
To those of you who aren't familiar,
"Averaging-Down" is the act of adding to an existing position. It
has a very negative connotation in the trading community. This is
because averaging-down on a trade usually happens when a trader is
in a losing position, and rather than getting-out of the position
at his intended stop-loss point, he will over-ride his original
plan, and instead ADD to the position, in order to lower his
average entry cost by adding to the position at a lower price. The
psychology behind averaging-down is driven by the fact that the
market now doesn't have to "bounce" back too far in order to bring
the trader back to "flat" or "safe" price position.
From the viewpoint of a bystander,
averaging-down is a tough bet to take because in the process of
trying to get "safe," the trader will assume a greater amount of
Risk against a market that has already been telling him he was
wrong in the first place, by moving against him. To challenge the
market is not a very smart thing to do, it is infinitely bigger
and stronger than we are. We, as traders are just "Davids" and the
market is like "Goliath." And while the story says David will win,
allow me to humbly assure you that in the Stock Market, GOLIATH
ALWAYS WINS.
You see, we have to love and "listen to"
our losers. They are the market's way of telling us that we are
wrong. Some will listen, but unfortunately, most will not. It's
not because people are inherently hard-headed. It's because most
of us are wired from childhood to "never give up." And so when we
get into losing positions, we have an innate tendency to "not give
up" and add to our losing trades. This of course just perpetuates
a very clear problem. But when you choose to participate in the
markets, we have to learn that "giving up" is an elegant thing to
do. In fact, it's a whole part of the game, somewhat like poker:
where "folding" is part of a larger, over-all strategy. In order
to survive the markets, we will have to go through the process of
un-doing a lot of our innate tendencies, and to think in the
opposite direction. To "fold" when it's time to fold, rather than
try to play hero. In the markets, there are a thousand dead heroes
for every one that's still around.
When we over-ride our intended stop-loss
point and add to the losing position, we put ourselves in a
position to make a series of mistakes that could be catastrophic
now, or if it doesn't happen now, it is bound to happen in the
future. By averaging down, we challenge the market's signal that
we are wrong, rather than listen and adjust to it by "folding" and
coming-back with a new strategy. While averaging down will save
you on some occasions, it is what ultimately destroys most
traders.
In fact, a trader who has a habit of
"averaging-up" (adding to a winning position) is likely to survive
longer than a trader who has the habit of "averaging-down." Think
about it.
"Good" Averaging and "Bad" Averaging
In my Risk Management lectures, the topic
of averaging-down is often discussed. And while I advise my
students against averaging-down, there is a critical distinction
that needs to be made. You see, there is "Good" averaging-down and
"Bad" averaging-down:
"Bad" averaging is exactly what we had
just discussed above: the act of over-riding an original stop-loss
point (changing original plan), and instead adding to the losing
position in order to lower the cost average and closer to a
perceived "safety" in price.
"Good" averaging is when the position
added is part of the trader's original plan to DISTRIBUTE RISK. By
dividing his default position size, he develops a PLAN, well
before the trades, to enter the market in at least two separate
locations. This can be planned either way the market goes (up or
down), and in the process of planning entries, he also develops
the areas at which he will stop-out of his positions. By varying
his entry and exit points (in both PRICE and TIME), he is able to
distribute his risk across a range in the market's motions in
order to capitalize on what he expects to be a sustainable trend
out of a particular range in time and price. In the process, he is
able to minimize risk versus the selection of one particular
entry, which focuses ALL risk into one singular spot. This is even
more applicable in volatile markets. So planning different entry
points for a trade is part of a larger over-all strategy in Risk
Management.
"Averaging-down" is not all bad. We just
have to distinguish between "good" and "bad" averaging. And the
difference between the two, is whether the follow-up entries were
pre-planned or not.
Fernando Gonzalez for Online Trading Academy
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