Stay Away From This Trading Behavior

| October 21, 2009 | 0 Comments

Think of a bad behavior.

Texting while driving comes to mind.

I risk sounding like your mom for bringing this up.  But texting while driving has got to be one of the most irresponsible things I’ve ever seen.

You’re focusing your attention on a tiny keypad instead of the road? Now you’re driving a vehicle like a baboon in a circus car.  Paying no attention to what, or who, lies in your path.  Incredibly irresponsible if you ask me.

Officials say texting while driving is just as dangerous as drunk driving… if not more so.

Now, let me get off my bad driving behavior soapbox and jump onto my bad trading behavior soapbox…

One of the worst trading behaviors is called averaging down.

Averaging down is entering a trade because you think a stock is “cheap” (or some other fundamental reason) and buying more as the price goes down.  It’s basically saying, “I’m not really sure what’s going to happen but it looks “cheap” here.  If it goes down, I’ll buy some more.”

You may ask, “Why is that such a big deal?”

It’s a big deal because the market can price your stock at “irrational prices” longer than you can stay solvent.  You’ll get to a point where the loss will be larger than you can handle.

Transocean (RIG) is a premier offshore oil driller.  Major oil companies contract them to bring up oil from deep beneath the sea.  Net income went from $1.3 billion in 2006 to over $4.2 billion in 2008 – A jump of 223%.

RIG was in a high demand industry with oil trading at $147 a barrel. The world needed more oil and RIG knew how to get it.  When RIG pulled back to $120 from its high of $160, many thought this was a chance to get in “cheap”.

As you know, in 2008 we started into a recession and soon after a financial meltdown.  In the second half of 2008, RIG started getting really fundamentally “cheap”.  Amateur traders kept buying.  Pretty soon it was apparent that the economy was in big trouble.

What do they do now?  Buy more?  Cross their fingers?  Pray?

The trader becomes the investor.  He keeps holding the stock trying to wait out the market.  Prime trading opportunities pass him by because his money is tied up in this “cheap” stock.

By averaging down, you’re breaking one of the cardinal rules of trading.

You’re failing to control your downside risk.  Never let a losing trade turn into a long term investment.  Always have an exit point for every trade.

A stock may be cheap by your metrics (RIG was no doubt fundamentally cheap), but ultimately the market is always right.  It can value the stock wherever it pleases and keep it there for longer than you can stand.  And there’s nothing you can do about it.

The only time averaging down is acceptable is when you plan it at the beginning of the trade.

Professional traders can average down and get away with it.  They understand the concept of risk control.

A professional may sound like this, “I’m going to buy 200 shares at $120 and 200 shares at $118 for a total risk of $800.  I’ll have a stop loss at $117 if I’m wrong.”  Professionals can control the downside risk by predetermining their exit point.

Most amateur traders don’t do it that way.  They just keep buying because it’s “cheap”.

Averaging down in trading is the equivalent of texting while driving. You’re setting yourself up for a big disaster if you do it.  You could literally wipe away a huge chunk of your portfolio under certain circumstances.

Never average down into a losing position without a plan to exit!

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Category: Technical Analysis

About the Author ()

Justin Bennett is the editor of Commodity ETF Alert, an investment advisory focused on profiting from the ebb and flow of important commodities via ETFs. The commodity veteran and options specialist is also a regular contributor to the Dynamic Wealth Report. Every week, Justin shares his thoughts with our readers on a variety of commodity-related topics. Justin is also a frequent contributor to Commodity Trading Research’s free daily e-letter. And he’s the editor of another highly successful and popular investment advisory, the Options Profit Pipeline.

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