Defensive Money Management Explained: The Death Trap Of Averaging Losers

By Lawrence

Written by Lawrence Chan. All rights reserved.

Note: Feel free to email me with your feedback lawrence@daytradingbias.com

Index Page

Averaging into a Losing Position

One of the most cursed bad trading habits that terminates many beginner trading accounts is averaging into a losing position (a.k.a. average down). To many traders who never really average into a losing trade, it is hard to explain why it is so addictive and sexy. For many traders who have lost a lot of money using average down, every time they are cornered by the market and lost their shirts because of averaging into a losing position, they would promise themselves not to repeat this mistake ever again, yet they keep repeating this same mistake all over again sooner or later.

Let’s take a look at how it all started for many traders to get addicted to averaging down. Surprisingly, many of these traders were profitable at least for a period of time.

One Miracle Turnaround Day

A trader who has a consistent trading setup of { 60/40, $150/$100, 1000 } is a decent producer of profits. But, one day, a bad trade hit the trader hard with a loss way bigger than $100, say $200. Many things can cause the bad trade to happen – not enough time to place the stop loss order, internet outage taking out your client side stop loss order, brokerage side failure that cancelled your stop loss order, or, you like to use mental stop and you could not pull the trigger to cut your loss at the predetermined level ($100 in this case). At this point in time, the trader sees another potential setup again. Isn’t it stupid to cut the position now as the setup is happening at the moment? Remember that the trader is not thinking straight at this point in time. A haste decision would drive this trader to add to the position.

And now, the magical moment, the market reverse its course and started to move in favour of the trader. The trader flat out the total position at the normal profit taking target for the second entry. $100 is made. It came from a loss of $50 from the first set of contracts traded and a profit of $150 from the second set of contracts traded.

Logical Handling of the Accident (or Mistake)

The trader is likely to ask the following questions,

  • Isn’t that a great discover?
  • Isn’t averaging down the greatest trading secret of all time?

Well, the answer is no to both questions, for this particular trader.

If this person is thinking logically, then the following calculations should be carried out.

1. Expected profit = (60% x $150 – 40% x $100) x 1000 = $50,000 a year

2. Cost of stupid mistakes, disaster events, and failure to cut losses on time

= % of losing trades x expected # of losing trades x absolute disaster stop amount

For 10% of losing trades having these problems, and that the trader is willing to accept the loss of $250 as the absolute stop point in his trading plan, then the extra losses (or cost of the trading business)

= 10% x (40% x 1000) x $250 = 40 trades x $250 = $10,000 a year

3. Net expected profit taking disaster events into account = $50,000 – $10,000 = $40,000 a year

Thus a logical person should add the concept of disaster scenario into their trade plans and having a predetermined resolution to handle such situation since that was not considered in the first place. Well, most retail traders teach themselves how to trade, it is understandable that the concept of disaster handling was not there in the beginning.

It is never too late to add it to any trading strategies. Then the trader should be able to continue trading profitable without averaging down.

Emotions Triumph Common Sense Most of the Time

But humans are emotional. Most of the time, the trader who just recovered from a bad day in trading using average down cannot see the potential complexities and pitfalls of the concept. More likely, the trader is exhausted from the day and can hardly think at all. The emotional sense of beating the odds and coming out ahead for the day overwhelm the person’s ability to reason. Averaging down becomes the lifesaver to the trader – an emotional anchor that gives the trader the potential feelings of getting high. It works very much like the addictive substances.

Thus the logical thinking scenario is not likely going to happen for an average retail trader. Instead, after a few episodes of such events, normal human will think that they must incorporate the great discovery of averaging down into their trading methods. That is the moment this trader throwing away the consistent profitable trading method he or she might have already discovered and steps into the world of averaging – a world not that friendly for those who are not prepared.

For those traders who do not have a consistent trading setup to start with, or, do not have an account that allows for averaging down multiple times, they will be cleaned out easily anyway with or without the use of the method. So the impact of averaging down for these individuals are significant but we will focus on those who originally having a reasonable performance.

Rosy Results Masking Out the Risk Involved

For those traders who do have a consistent trading setup to start with and that the account allows for averaging down many times, they are the ones who are most likely addicted to average down for life.

Not all trading setups allow for easy backtesting, thus many traders who have decided to incorporate average down into their trading styles may not be able to backtest the idea properly and see the potential impact in doing so. Not all traders are programming savvy either, that leaves them the only choice of manual backtesting to see the effect of average down which is something not many people are willing to do because manual backtesting is a very tedious task.

Here is a summary of the effects of average down on a reasonably performing trading setup,

1. The immediate impact of average down multiple times on a reasonably profitable trading setup is that the winning percentage will increase significantly. We are not talking about 60% going up to 75%. I am talking about 60% going up to 90%.

2. The amount of money made would increase several folds because there is almost no down day due to the high percentage of winning trades. Misunderstanding of such high winning percentage as skill improvements will burn deeply into the person’s mind that average down is the right way.

Luck is not a Dependable Factor

The problem, however, is that the trader is slipping unconsciously into overleveraging. In the second chapter, I explained that to increase the survival rate one must increase the capital behind each unit that you risk trading. For example, if the margin requirement is $5,000, and that the trader has $25,000 in the trading account, then as long as this trader is trading the profitable trading setup we are talking about in this chapter, it is very likely healthy profit is made after a year of trading.

However, if the trader chooses to average down on losing trades, then the margin requirement increases to a total of $10,000 when average down just once and that the real amount of money behind each unit traded is $25,000 / 2 = $12,500.

When the trader adds onto the position one more time, the total margin requirement increases to $15,000 and the real amount of money behind each unit traded would be $25,000 / 3 = aprox. $8,333. That leaves only $3,333 between the trader and a margin call.

As averaging down just once is not enough, the trader may choose to average down a few more times. Of course, a wild run of profit is likely because the original trading setup has its merits. But, the trader is stretching thin the amount of money put behind each unit added to the losing positions.

Remember that there is no sure thing in trading? As more units are added to a losing position, the trader is effectively betting all the hard earned winning over many trades behind a single trade. Probability will eventually catch up and all profits made from the wild runs will vanish in a trade or two.

Alternative Strategy Taking Advantage of Probability

The main reason for an average retail trader to fail at using average down is that they are averaging into the losing position without a plan. Proper engagement rules are not defined. For example, when is the right time to average down?  How many times of averaging down is allowed based on the account size and capital requirements?

Two logical views in dealing with the questions above,

  • The use of average down is the acceptance of your initial entry based on your trading setup is not necessary the best price level to enter the trade and that you know why that is the case. If you used to trade with a view of precise entries , then average down techniques are not compatible with your overall trading style.
  • You are getting ready to participate in market making activities in the financial markets. Thus if you choose to engage in average down, you must be properly capitalized. For most retail traders, that is not possible.

The reason for averaging down into a losing position is that you are expecting the reversal is coming soon, but you have no control over when your original trading setup is going to show up, and you have no control over how much the market is going to go against you before your trading setup will show up. We are talking about two unknown factors, or, in statistical terms, two new (almost) independent variables, meaning that you know absolutely nothing about them. If you have no idea what I just talked about in this paragraph, then it is not a good idea for you to incorporate what I am going to show you in the next section.

If you can accept the fact that you have to treat the occasional bigger losses from uncontrollable disasters as part of your cost in running your trading business, you have the right mindset to review the original trading setup again. Your willingness to let probability to work in your favour even though you have to accept the extra losses as part of the cost in running your trading business means that you should be able to utilize the following concept properly.

Lesson 4: Consistencies in Winning Percentage Combined with High Winner to Loser Ratio is Gold

You know that the winning percentage is 60% and to be conservative (as repeatedly pointed out in previous chapters) we should think of the winning percentage as 50% only. Then you know the following is true,

# of Consecutive Losers Probability based on 50/50 Probability based on 60/40
1 50.00% 40.00%
2 25.00% 16.00%
3 12.50% 6.40%
4 6.25% 2.56%

The odds of 3 consecutive losers is 12.5% if your trading setup is performing at 50/50. If it is performing at 60/40 it will be lower.

If you increase your risk size after 2 consecutive losing trades, you would be able to profit from the statistical bias. Using our example trading setup, if you double the risk size,

the expected return = (60% x $150 – 40% x 100) x 2 = $100

Do not underestimate this minor change of bet sizing rule. Let’s take a look at the expected net performance for the year

Expected extra gain if trading setup performs at 60% winning

= $50 x 16% X 1000 = $8,000

Expected extra gain if trading setup performs at 50% winning

= $25 x 25% X 1000 = $6,250

In short, if your trading model is performing at 50/50 or better, as long as your winner to loser amount gives you an edge by itself, you can choose to increase your risk (not double down – that is completely different) to improve your trading performance. For example, if you are trading conservatively using the 1% risk over 20% risk capital method mentioned in Chapter 3, then raising that to 2% will still be sensible risk taking.

When your winner to loser amount is 1 to 1, say, $100 to $100, or worse like $100 to $250, however, then do not think of double down. Your trading style does not give you the right combinations to take advantage of this hybrid average down strategy at all, even if your strategy has a very high winning % overall. The reason is that your potential return from using average down strategy will not be able to compensate for the potential losses you would have racked up against you already.

– end of part 5 –

Comments
  • Karish January 7, 2011 at 3:44 am

    LC, many thanks for providing different view on trading other than entries and exits.

    You mentioned that “double down – that is completely different” .
    Can you please explain doubling down statistical odds too.
    Thx.,

  • Lawrence Chan January 7, 2011 at 8:54 am

    Double down is effectively an accerelated form of average down.
    e.g. Bet size going from total of 1 unit to 2 units, then 4 units, etc.

    The “thinning” of money behind each unit of trade (i.e. contract or share) is much faster and can break an underfunded account way faster.

  • Karish January 8, 2011 at 12:45 am

    No doubt that the sizing acceleration would break unfunded account much faster, on the other hand, break even and also predetermine target are closer. Given that the account is properly funded and trader know what he is getting into, how can we calculate the statistical odds for this situation?

  • Lawrence Chan January 8, 2011 at 10:21 am

    The key to averaging down (and also double down) is that the method or model is designed in the first place to work that way. It is something more related to trading model design than pure money management that I intended to focus on in this series.

    First and foremost, an average down model should not focus on identifying “turning points” (i.e. precise entries). Instead, pay attention to longer term mean/mode reversion properties of the instrument traded.

    When I start writing about trading model designs, I will likely spend several parts on this topic alone. The concept is not complex, but it takes a lot of planning on many details to get an average down model to work properly and consistently over time.

  • aparekh August 20, 2013 at 3:31 am

    Good article Lawrence.

    Averaging down works only when trying to build positions in a price zone instead of specific price but with a predefined loss level. Most mean reversion strategies can use averaging down properly if and only if there is a set stop point (assuming say short position of say 1000 shares need to be built, so 1st entry of 200 shares at price x, market moves higher and another 200 at price y and final lot of 600 at price z by which the entire position is maxed out and the move is possibly exhausted). If it continues to move higher then one absolutely needs to get out with loss but for most part since mean reverting is in play, it will yield profits).

    Maximum damage in this case will be strong trending days which don’t happen that often but can wipe out previous gains quickly. So for the average novice trader, averaging down is a strict no-no and can be useful only when trading with trend (buying dips and selling rallies via averaging).

    By the way can you write more about the “average up” strategies (i.e adding only when position moves in favor).

  • MidKnight August 20, 2013 at 8:35 pm

    Hi there,

    The problem with what you write above aparekh, is that you may need to get 1000 shares filled with intent to do this as price moves against you in multiple stages – however, there will be many times you aren’t able to get the boat full, so to speak.

    The obvious choices I see to this if one is choosing to average down are:
    a) must also have a way to average up
    b) as it moves against you continue the average down but use these as price improvement from the first entry with the intent to average up to build the position

    Some problems but not limited to are:
    – if you are only averaging down, you assure the losers will likely be hit fully loaded while you will get many winners that are with small positions relative to the loss.
    – if you go with option (a) above, then….well…how this option usually works for me is quite badly. End up worsening average price so don’t get enough room to endure swing trade wiggles.
    – if you go with option (b) above, once it finally gets moving I have extreme difficulty averaging up. Maybe its because the position starts out with a average down price improvement mindset and transitions into an average up mindset and my mind doesn’t handle the transition well. Maybe if you could set up some sort of trade management bot for this it would help immensely. Difficult for me to do under discretionary methods I use.

    I still feel that average down could have a real benefit to my swing trade model so I continue to think about it and explore approaches. So far I’ve had difficulty making it work.

    With kind regards,
    MK

  • MidKnight August 20, 2013 at 9:34 pm

    May I add too….take a look at myfxbook dot com, search for systems with real accounts alive for longer than a year with say a max 30% drawdown. The majority of the top 10 systems are doing some sort of average down approach, many of them look to just be grids. Some astronomical returns there and utterly incredible win rates.

    Food for thought.

    With kind regards,
    MK

    • Lawrence Chan August 22, 2013 at 2:00 am

      Average down and not taking losers (or not having a stop) is actually a well researched concept. Most famously done by Lawrence Connor showing that daytrading with stop with whatever model you use are likely better off without using any stop.

      But then we experienced the 2008-2009 financial mkt melt down.The new knowledge from that period tells us that proper money management has a place in trading.

      Trading models that average down multiple times are a form of curve fit against the known distribution of the data series. If the characteristics change, the average down models will suffer steep equity losses.

      When I get the time to write on the subject, will address this issue and how some modern hedge funds resolved the problem in more elegant ways.

  • MidKnight August 22, 2013 at 10:02 pm

    PLEASE do that Lawrence – I’d be fascinated to hear. It’d make a great premium article!

    All my best,
    MK

  • Kpup2 August 31, 2013 at 10:24 pm

    LC:

    “Net expected profit taking disaster events into account = $50,000 – $10,000 = $40,000 a year”

    This is wrong. You have double counted the impact of the “10%” of the “40% of your trades (i.e. the Losing trades)”. The answer to your example should be $44K

    • Lawrence Chan September 1, 2013 at 10:09 am

      Good catch.

      The correct answer should be,

      10% x (40% x 1000 trades) x ($250 max loss – $100 usual loss)
      = 10% x 400 losing trades x $150 extra losses
      = $6000 extra losses

      And that makes it even more compelling to use a disaster stop, isn’t it?

  • You must be logged in to comment. Log in