ok guys i have some MUST READ AND RARE quotes from Millionaries Trader book about misconception of averaging down and why people think it is bad. I repeat MUST READ! (pasted below)
Q: Do you average down into a trade?
A: This is going to cause some controversy—but a qualified yes. Let me stop the controversy though as much as I can. I realize as much as anyone else that averaging down has led to some of the biggest debacles in our industry. The idea of averaging down is where if you are buying an asset and then it goes against you. You
start buying more. You are getting hurt by reverse compounded interested. Not only are you wrong, not only is your net worth declining, but you’re also increasing your risk. Now I know that is a recipe for disaster and most people should not even do it.However, there is one other thing that’s been happening in the past few years and that is you identify a great asset class that you want to own for whatever reason. You’re thinking about buying it, and you’re sitting there and sitting there, and because of the world we live in and the amount of money that is going into these markets, all the managed money as well, and the amount of people who are
using black box or some type of trend following system designed to Basically exploit trends. You might be watching this asset class with a whole bunch of other trend followers. They’re going to get into the asset class make it go further and further away from you. You have a choice to make because you may think that this is a great asset class that I want to own it. I hope to own it at lower levels, but the trend guys are in there and they’re pushing it and pushing and it’s getting away from me. I’ve got to buy some now and get some exposure because the worst thing you can ever do is be right about an investment, researched it, it’s correct and it goes dramatically in your favor and you’re not even on board. I mean that’s going to lead to huge underperformance or maybe losses for the year. Sothey’re going to get in, you’re going to get in with them, and the Achilles heel of every trend follower is this following sentence: You cannot pick up a trading book without reading it. In fact, you’ve heard it all before. To be a good trend follower you’ve got to cut your losses and let your profits run. In that statement is the Achilles heel of their trading strategy. They’re going to cut losses, which means they’re going to take a lot of whipsaws and they’re going to let their profits ride, which means they’ve got to suffer huge drawdowns before they get out of their trades. Let’s focus just on the cut your losses side because that is what is applicable to my averaging down. What happens is that I’m going to get in with all the trend followers and you then have the reaction, which is then going to cause the trend followers to further that reaction by cutting their losses, which is going to create more pressure on the down side. At that stage I may relook at this thing and say, “You know, it still looks like a great asset class, I still want to own this
thing for whatever reason.” I know it’s gone against me, but I have to commit more capital here. Usually I’ll let it drop two, three, four days against me, and I’ll wait for it to show that the trend is going to continue before I pull the trigger again.
Q: You wait for prices to stop going down and going against you?
A : Yes. I’ll give you one example that I use. Technically I’ve seen and I’ve tested on Trade Station that Markets that are in good uptrends and followed by trend followers, have anywhere from two-, three-, or four-day price drop correction, which is, in my mind, a reflection of the trend followers cutting losses. If the trend
is over, this might not apply. But frequently what I’ve found is that the trend is going to reassert itself. What happens is the market eventually takes out it’s high the day before and, let’s say, we had a three-day correction. So you had down moves day one, two, three, and on day four I’m watching and I’m thinking, “Are they out? Are they out? Are they out? I don’t know. I don’t know.” I’ve reevaluated everything. I’ve probably spent hours thinking about if I’d do this trade again and all of a sudden it takes out yesterday’s high. At that point, most likely, I’m going to start to execute andbuy and basically this is my averaging down. I figure that this trend should now snap back, it should continue, the trend should go up and at that stage, I do tighten up my stops. I will look to suffer less standard deviation risk because, by my logic, this should be over. We’ve just had a pretty good standard deviation correction in prices—I think that the trend followers are out. If this is a real trend, it should reexert itself. If it doesn’t now, I’m out because I’ve doubled up and I am in a risky position. If it goes wrong, not only do you have a move that is one standard deviation worse than I thought, we’re now exploring standard deviation two, so I’m out.
Finally, there are two pieces of advice in commodity trading legend which has been passed down through the ages as gospel. One: “You must cut your losses and let your profits ride!” Two: “Losers average losers!” Both are conceptually correct, yet the logic of both has been blown out of proportion, if not twisted, over time. Today it is considered a sin for any self-respecting trader to not cut losses quickly, sometimes too quickly. Today it is also a trading sin to average losing trades. We need to reexamine these ideas with a greater level of maturity and sophistication in order to continue to be able to win at trading in the future. In 1974 Muhammad Ali in the “Rumble in the Jungle” against George Foreman in Kinshasa, Zaire, used a strategy in boxing that was considered a boxing sin at the time to become Heavyweight Champion of the World against great odds. It was the so called rope-a-dope strategy. The theory at the time was that lying on the ropes was wrong because it exposed a fighter to more punishment than if he moved around the ring. This did not discourage Ali from using the strategy against Foreman. Foreman was a harder puncher than Ali. Most analysts felt that Ali would have to stay away from Foreman to beat him. Instead, Ali started to lie on the ropes by the end of the first round and used the ropes for the rest of the fight. Foreman’s strategy, which was totally obvious (just like cutting losses and letting profits run in trading) was to cut off the ring, get Ali to the ropes and hit him. Since Ali was willingly lying on the ropes, Foreman would plant himself in front of Ali and punch as hard as he could. Foreman landed constant blows to the body, but due to Ali’s focus on protecting himself had trouble landing to the head. Ali scored on Foreman with an occasional jab or series of jabs as Foreman tried to reposition himself or catch his breath. Foreman began to tire from all this activity (in tradingterms, getting repeatedly stopped out and then trying to reenter at worse levels) and from the occasional punches he was taking from Ali (in trading terms, the actual capital losses related to the stops getting hit and possibly not being able to reenter at favorable levels). Foreman was visibly finished by the end of the fifth round and eventually knocked out in the eighth. If Clint Eastwood can take great trading advice and apply it to boxing, perhaps I can take great boxing advice and apply it to trading. The greatest boxing advice I could find inverted a boxing sin and converted it into a favorable outcome against great odds. This advice came from the greatest boxer of all time, Muhammad Ali. Thank you, Muhammad Ali, you have always been a hero. My commodity trading version of rope-a-dope is to take a commodity trading sin. That is, not cutting losses quickly and then making it worse for a brief period of time and space—but don’t expose yourself too long—by adding to the loser trade. I have
found that in the long run I am achieving better results, behaving with better discipline and emotional control than the people who mindlessly cut losses too quickly and won’t even consider averaging down to improve odds. Warren Buffett once said, “I buy a stock I like for 100, it goes to 90, I still like it, I buy more. How is that more risky?” Just like Warren Buffett, I also have trouble perfectly timing trades. This strategy has at time enhanced my performance in spite of my initial poor timing. It definitely involves superior discipline and emotional control—try it sometime—than someone who allows themselves to get whipsawed too soon out of a perfectly good trend. My risk is increased for only a very short period of time and movement. Be careful about exposing yourself for too long. My opponents are getting tired out both in terms of physical capital and mental capital due to the fact that they got thrown out of a good trade too quickly and now must try—and I emphasize
try—to reenter later, most likely at higher prices, and with less real capital and less mental capital than when they started. Constantly getting stopped out and trying to reenter trades is very tiring from both a mental capital and physical capital perspective. Please, don’t take trading lore for granted. Step back and try to take a more mature and sophisticated view of how to achieve results. “Whipsaw is for losers!” Did you ever consider that? If so,I hope you will find your own version of the rope-a-dope strategy. You will need to first understand the concept of value for buys and possibly the concept of hysteria for sales as well as the concept of margin of error for both buys and sells. I wish you all the best of luck in your endeavors.
