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Trading Trail #4: When it’s OK to Average Down

Nov 5, 2011 at 1:57 am in Trading Diary by

Yesterday I told you that I had bought in this account additional positions in stocks that I held in another spread betting account. The good news is that I did so at lower (‘even better value’) prices, and the bad new was that — in effect — I had averaged down. While averaging down is generally frowned upon in trading circles, for good reason, I felt justified in doing so because I was establishing the new positions at less risk. Let me explain.

In a traditional share dealing account you risk £1000 if you invest this amount in an equity priced at 100p-per-share, and you risk another £1000 if you invest the same amount again at 50p-per-share.

In a spread betting account you risk £1000 if you bet £10-per-point on a 100p share, but a lower £500 if you bet an additional £10-per-point on the same share when it is priced at 50p-per-share.

It’s still averaging down, but at less risk each time providing you apply a stop order at the same level (or none at all) on every subsequent bet.

A ‘mother’ of a troublesome position

I don’t need to tell you that I’ve been in and out of Mothercare stock like… I can’t say what, because this is a ‘family’ show.

01/11/2011 Bought @ 162.3

02/11/2011 Stopped Out  @ 157

03/11/2011 Bought @ 154.1

..and then today:

04/11/2011 Stopped Out @ 149

04/11/2011 Bought @ 148

On the one hand, I’ve lost a total of £10.40 in whipsaw-like losses thanks to these stop-outs. On the other hand, by stopping out and the re-buying at an even lower price (never higher) I have saved myself from £3.90 worth of additional losses that I would have sustained if I had simply held on from 162.3 down to 148.

So I’ve beaten the buy-and-holder as long as I find myself still in position and not stopped-out when the hoped-for up-trend develops. If I find myself out of position then the buy-and-holder will be the one laughing last and laughing longest.

A guaranteed stop

In theory I like guaranteed stops, who wouldn’t? But in practice they can be unattractive because of the costs. Today I guaranteed my stop on Aviva because:

  1. The minimum stop distance was no further away than where I wanted my stop to be, at 317p, so I’m not taking on any more risk in exchange for the guarantee.
  2. The £1.58 cost of this ‘insurance’ is minimal compared with the fact that I could lose more than £300 on this £1-per-point position if the company declares bankruptcy overnight!

Having shown a paper profit of up to £20 during the day, this position has come very close to stopping out at the guaranteed price, so I’m not optimistic.

A bet on Balfour Beatty

The only other action today was a new long trade in Balfour Beatty at 243.7p with a tight stop order at 237p.

Tony Loton is a private trader, and author of the book “Stop Orders” published by Harriman House.

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