Sunday, August 22, 2010

Should you average down?

The general rule of thumb is that traders should not average down. Instead they should cut loss quickly. Buying more shares at lower prices than what you initially paid is called averaging down. This strategy may work well for investors. But for traders, it is as dangerous as catching the falling dagger. If you are not careful, averaging down can turn out to be a catastrophe.

Once a trader told me that when he bought, he must see the money in the next 15 minutes otherwise he would cash out and called it a day. My first thought was that he was being boastful. When I thought about it later it. I realize that his strategy is not unreasonable.

As a trader, you don't buy a stock that is in static mood. Only when a stock shows that demands have picked up and prices are moving will any bet be placed on it. When a stock is moving, its price can move fast and assumed to continue. If however, the price retraces back the moment you put in your money, you should cut loss when the price hits a certain predetermined point. This is called cut loss. You don't allow the loss to become bigger. Thus, you have to be on your toes all the time.

When you lose, at what percentage point should you cut loss? This depends on your risk tolerance, the amount of money you can afford to lose and also on your personal character. Some will not allow the loss to be more than 10% while others may allow a bigger margin. Note that the lower the price, the easier the 10% will get hit. For those who study charts, they will probably place the stop-loss slightly below the latest support level.

Cutting loss is probably a good strategy. The idea is lose little when you judge the market wrongly and to win much when you are right. The problem is that you may not be able to carry out your plan as planned. To cut loss is to admit that you have made a mistake. Believe me, many people are not able to do that.

A trader does not have to know about the stock's fundamentals because his romance with it will last only for a short time. Just like when you go for a fling, you don't have to know too much about your partner.

If you are an investor, averaging down is a good strategy. I shall tell you why and how you should do it some other day.