Why “Averaging Down” on a Trade Is a Bad Idea

It took Martin just a few months to blow up his entire account.

In mid-2001, Martin bought 1,000 shares of Polaroid at $10 apiece. The company had fallen on tough times. The stock had already plunged more than 50% on the year. But Martin was convinced it would turn around.

“Blue-chip stocks don’t just all of a sudden go out of business,” he said.

The stock dropped to $8. And Martin bought 1,000 more shares.

“It’s a steal at this price,” he said.

Polaroid then fell to $5 per share.

“I’m not worried about it,” Martin claimed. “I’ve done the math. All I need to do is buy 2,000 shares here at $5. Then when it pops back up to $7, I can sell everything and break even.”

You can probably guess what happened…

The stock didn’t pop up to $7. Instead, it fell to $2. And that’s when Martin got aggressive. He bought 20,000 more shares.

“My average price is now less than $3 per share. I’ll make a killing when this thing bounces.”

The problem was… Polaroid never bounced. A few days later, it traded for $1.

Martin was desperate. He had “averaged down” on a bad trade.

This one stock now made up most of his account. And it was sinking… fast.

Martin started scribbling out another order ticket. Most of the traders around Martin thought he would finally bail out of the trade. He’d sell Polaroid for whatever he could get, lick his wounds, and then move on to getting his account back up.

But that’s not what Martin did. Instead, he filled out an order to buy another 30,000 shares of Polaroid at $1.

“What else can I do?” Martin asked as he handed his order to the trading desk.

Under his breath, another trader whispered, “You could pray the stock drops to 10 cents. Then you can buy a ton and really bring down your average cost.”

Less than one week later, Polaroid stopped trading at 28 cents per share. The company declared bankruptcy. The stock never opened for trading again.

Martin had blown up his entire account. $98,000 of his money had disappeared in a matter of months.

“Averaging down” on a losing position is almost never a good idea.

The only time it makes sense is when you make it a part of your strategy from the beginning… like if you take a smaller-than-normal position, expecting to be early on the trade. That would give you some flexibility to slowly build the position to a normal size.

That’s the only time I average down.

Every other time leads to traders taking on too big of a position. They get overleveraged. They get committed. Then they get emotional—which creates another set of problems.

When there’s too much money at stake, traders tend to make bad decisions. They don’t sleep. They eat poorly. They go to the bar after work.

None of that leads to good trading.

Also, traders should never average down when buying options. As time passes, the price of an option falls. Time works against you.

In my early years of trading, I flushed so much money down the toilet trying to turn a profit by averaging down on options trades. It would work, maybe, 10% of the time… But 90% of the time, I would quickly regret that decision.

Leveraged funds fall into the same category.

Most leveraged funds use futures and/or options contracts to double or triple the returns on their respective benchmarks. Like with options, time works against them.

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Some traders will argue that averaging down on individual stocks is different.

Remember what Martin said: “Blue-chip stocks don’t just all of a sudden go out of business.”

By averaging down, these traders say, you can bring down your cost basis and make it easier to turn a profit on the trade.

But if you average down and buy more shares of a losing trade, you run the risk of exponentially increasing your losses. Even worse, you run the chance of getting emotional on the trade and hanging on “no matter what.”

That usually doesn’t work out well.

Just ask Martin.

Regards

Jeff Clark
Editor, Delta Report

P.S. In my daily newsletter, the Market Minute, I share my thoughts on how the major markets are setting up for the day’s trading… and provide insights to help you reduce risk while boosting your returns. It’s how I’m going to trade my own money each day.

To automatically receive the Market Minute for free right to your inbox, click here.

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Editor’s Note: Last week, PBD analyst Nick Rokke told subscribers he’ll be traveling to the Rust Belt states and parts of Canada at the end of May to get a firsthand look at how the global trade war is affecting the American economy. We asked for your feedback. And we’re getting plenty of stories from the front lines…

From Elcio M.: The only feedback I can tell you about the Canadian economy is there’s a silent tax showing up through inflation. Even groceries are becoming too expensive. There’s also a carbon tax included in our energy bill and that’s raising prices.

From Don S.: I own a small business in Parma, Ohio. So far this year, we’re having the best spring season in nine years. We don’t advertise but have only increased our online marketing. Almost 90% comes from word of mouth. We are a 20-year-old floor covering business. Other businesses of the same type are not experiencing the same.

If you live in the Rust Belt and have a compelling story about the global trade war, send it to us right here. Meanwhile, one subscriber says the trade war between the U.S. and Canada is not all Canada’s fault…

From Jeff J.: In your “Blame Canada” issue (April 20), you mentioned that Canada had filed more trade complaints (39) than Mexico (23) against the United States.

At least one of those complaints was about something already banned in the U.S. that Canada also banned—a deadly toxic additive to gasoline. The company that makes this American-banned product sued the Canadian government for hundreds of millions of dollars. And won.

So don’t go making Canada the only bad guy in these trade wars. NAFTA says that any company in any of the three countries can sue either of the other two countries if its profits are affected, even if the product/service is banned in the home country.

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