Average position price averaging is a great tool in the right hands and a recipe for disaster if mishandled. Averaging – entering a position in parts when an asset moves. For example, let’s say you want to invest 10,000 in an Apple share. But you do not enter at once with the entire amount, but invest in three passes: 35% now, 35% with a price correction by 10% and 30% with a 20% correction. That is, you are placing the possibility that the price will move against you, but not more than a certain amount.
The chart shows: you entered at 220, then at 200 and then at 175. In the first case you bought 16 shares, in the second 17 and in the third 17, for a total of 50 shares. And the average entry price was $ 197.9. This is your position breakeven point.
There can be four or more steps in averaging. And you can also average when moving up.
For averaging, it is important to observe the following conditions:
- You must have a special view of this asset, either bullish or bearish. If you have a bullish outlook and the price starts to fall due to news that changes your outlook, then you need to exit such a position with a loss.
- You must have an entry plan. Namely, where and for how much to buy (sell) an asset.
- You must have an exit plan. Where do you exit and under what circumstances.
- You must have control over the overall level of risk and capital for this position. If this is 10,000, as in our example, then we do not invest more, even if we really want to buy more. If the stop is at the 30% mark, then you need to exit when you reach the mark.
The main problem with this approach is when an investor or trader confuses a temporary correction with a new opposite trend and fights the market. But the investor and the trader always lose.
It reminds me of my own pain when I neglected these conditions. I successfully traded SP500 averaging (I was day-trading then). I bought each correction with a certain step down. Everything went great for a month. I never went more than 4-5 steps down. I have always monitored the market before entering and entered only bullish (in my opinion) days. And then one warm Friday I started trading SP500 and everything went well. But then news of medium content came out and the market began to correct. I began to average. But in four hours I averaged 18 times (the step was fixed)! I was long 18 SP500 futures totaling $ 2.2 million (notion value) in a falling market on Friday night! At that moment it was a very large position for one day and my nerves began to fail. It hurts. On the next upward correction (in my direction), I closed the position with a loss. My capital was minus 5% in one day. Not only did I give everything that I earned on SP500, but I also took my capital away. Then I beat off the minus and several years have passed, but I remember that Friday clearly. The market then fell, but came back on Monday. Pure speculation, but my position was too big for me then. The overall risk must always be under control and an action plan must always be at hand. People lost their fortunes on averaging. I will write about this separately.