Money Management and Averaging Down
Oct 17, 2011 at 11:23 am in Risk Management by
In my article I introduced the topic of ‘money management’ (or what we might call ‘capital preservation’) by telling you about Martingale and anti-Martingale betting strategies.
One form of Martingale strategy that is often implemented by novice investors is the practice of ‘averaging down’. You know the routine:
The stock that you purchased at 500p-per-share is now down at 250p-per-share so you buy some more at the even better price. You have reduced your original purchase price to a new ‘average’ purchase price of 375p-per-share, so you think it will take less of a recovery in order for you to break-even.
But what if you put in £10,000 the first time, £10,000 the second time, and you only had £20,000 to start off with? If the price chart subsequently shoots to the moon, you’ll be a hero, but if the company goes bust you’ll be left with zero. Game Over!
Okay, so you’re not that stupid. You put just £1,000 into this stock the first time, and another £1,000 the second time. When it halves again you put in another £1,000, and then again another, and another, chasing it down all the way to zero. Suppose you did this in the past few years and the stock in question was Woolworths, or Southern Cross Healthcare, or Connaught, or… the list goes on.
Diversification should save you, unless you were diversified across the three stocks just mentioned, but of course you wouldn’t be diversified across only three dog stocks. Or would you?
In reality your initial twenty-stock portfolio would have reduced to just those three stocks as you sold out of other profitable positions in order to fund the additional even better value averaged-down purchases of those losers. In an averaged-down portfolio, the dog stocks become magnets for your investment capital.
So much for ‘investment’, but what about spread betting?
Well, I have some good news for you.
On a pounds-per-point basis (rather than a equal-sized investment basis) your averaging down would be rather more anti-Martingale because you’d be allocating less of your trading capital on each turn:
- Betting £1-per-point on a 100p stock risks £100 in the absence of a stop order.
- Betting £1-per-point when the stock has fallen to 50p risks only £50 more in the absence of a stop order.
- Betting £1-per-point when the stock has fallen to 25p risks only £25 more in the absence of a stop order.
Each time you ‘average down’ on a fixed pounds-per-point position sizing basis, you’re doing so with less additional risk. From a money management perspective it’s an improvement but beware that if your chosen stock goes to the wall, you’ve still lost everything you’ve staked — so make sure it’s not everything in your account!
Tony Loton is a private trader, and author of the book “Position Trading” (Second Edition) published by LOTONtech.