Thursday, August 14, 2014

Yes, I Average DOWN!

You've heard it from traders everywhere. "Do not average down." "That's how you blow up your account." "Stocks can fall farther than you think."

No matter. I average down, and it works wonderfully.

How does it work? Here's a chart of BCRX - a trade I took this week.

BCRX 30-min

I had a support zone mapped from the doji candle on the left of the chart. You can see my zone marked from $13.13-$13.32. Before you average down, you need a defined stop. Mine was $13.09 - just under the support zone. My target was $14.07.

Had I played it by buying a full position at $13.32, I would have been risking $0.23 for a gain of $0.75 - just over 3R profit. That by itself makes this trade worth taking. I like to set my limit order at the top of the zone because in the past, I've had it bounce off the upper line to the cent and take off from there.

Now, let's assume I have an account size of $30k. 1% risk is $300 with a reward of $900. That makes for 1363 shares. ($300 total risk divided by $0.22 per share risk).

However, I PLAN to average down. In doing so, I don't have to be perfect on my entry. Here's how it works - my first entry will be at $13.32. My second entry will be at $13.22. My third will be at $13.17. All three purchases will be of an equal number of shares. These three entry points will make my average entry $13.23. Now with an average entry of $13.23, I can buy MORE shares overall to keep my risk the same. Now I'm going to be buying 2142 shares to keep my risk at $300. ($300 total risk divided by $0.14 risk/share). This means each entry will be 714 shares. (2142 shares/3 entries)

Now let's assume all three of my entries were not hit. Overall risk will be $300, because I'm PLANNING to average down.

If only my first entry was hit. I would have 714 shares at $13.32, and my target hit @ $14.07 would make for a profit of $535.50. This is a 1.79R return. Still a good, profitable trade.

If only my first two entries were hit before my target, I would have 1434 shares at an average price of 13.27. This makes for a 3.82R return. Way more than if I had bought a full position to start out with.

If all three of my entries were hit, I'd have 2142 shares at an average price of $13.23. Hitting my target before my stoploss makes for a profit of $1799.28. That's a 6R return!!!

So yes, I do highly recommend averaging down, even though it's against common advice. As you can gather from the bold text above, the key is you MUST PLAN to average down. NEVER EVER AVERAGE DOWN A LOSING POSITION UNLESS YOU PLANNED FOR IT BEFOREHAND!


I had a conversation with @ckz8780 on Twitter about averaging down which got my brain turning on how it can work. A big thank you to him.

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