The dangers of averaging down in Forex
It’s funny, but when you look for the term averaging down to talk about speculation, all you read are negative comments. Most traders say that averaging down is a really bad idea and the path to lose all your money in the trading account.
When we talk about investing in stocks, it is not so rare to talk about investors that average down. I recently read that Warren Buffett bought more IBM shares, averaging his average entry price, Warren Buffett averaging !!!. If the best investor in the world applies this strategy, maybe averaging down is not such a bad idea.
You really should not confuse two similar but not synonymous terms: invest and speculate. In Forex we do not invest but speculate, but that does not mean that the averaging down can not be applied, but the risk is much greater.
You’ve probably heard about Grid Trading. This Forex system or strategy, uses something similar to averaging down, ie buy more, increase your position when the price goes against you, either upward or downward. However, we must clarify that grid trading averages, but it tries to get out of the operation as soon as possible, taking advantage of the lateral movements to increase its winning trades, but that does not imply that we are actually using the averaging down to try to beat the market.
I have long seen a professional trader, always on very long-term charts, building a position in EUR/USD, looking for a trend change. He was adding short contracts, as the price rose from a certain level, where he expected a market turn. So averaging down is not so crazy, but within the reach of a few traders.
Averaging down is bad, very bad, when the trader does not know what he is looking for, or is not within the trading system.
The trader I refer to probably had an account large enough to withstand major losses, and he was very clear about what he was doing (this trade worked out well), since he planned all the operation establishing where he would add new positions and where he would accept that he is wrong and close all positions with losses. He had “a plan”.
In Forex we use margin accounts, we are trading with leverage, and that means that averaging down in Forex is really dangerous. A miscalculation can wreck an account, especially a small account.
Pyramid trading is not averaging down
Another concept that is sometimes used is pyramid trading or pyramiding. Pyramiding in Forex or in any Trading strategy, is exactly the same as averaging down, but with the trend in favor of our initial trade.
We could say that the risk here is low or zero, since if the price goes in our favor, we add contracts to a winning position, which we will do to increase our profits.
Traders do not usually use this trading technique very much, since it is difficult to escape the psychological problems involved, to buy something more expensive when a few minutes ago we could have bought it cheaper, it is something that psychologically is not easy to admit.
Within the psychology applied to trading, there are many biases that make traders inefficient. One of these problems is precisely the asymmetric way of understanding the gains and losses.
For most traders is more annoying to have a streak of continued losses than having a big loss in just one trade. We also react differently to a winning trade than to a losing trade. When we are facing a trade that is in our favor, and we are in profit, the temptation to close that position, even if it has not reached our goal is enormous. According to statistics, a winning transaction is 50% more likely to be closed early, than closing a losing position before it becomes a problem.
So is averaging down allowed or is it a bad idea?
Everything that goes beyond what we have planned before starting a trade, is totally forbidden. Any trading system, even the best systems, should include basic and very important aspects as the position size and the rules to open and close a position.
For example, a place we could try to average down are the areas in which we expect a market turn. Imagine that you are waiting for a trend change, but you do not know exactly where it is going to take place and despite this you do not want to miss the opportunity.