| 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.
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