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When one tries to average a position, the markets seem headed in one direction, thus increasing the loss manifold. Any way out of this?
Ramani, Hyderabad Opinion is divided about the utility of averaging. The experience of many is similar to yours, wherein the stock price keeps falling lower. If you keep adding to your position under such conditions, the loss widens. Let’s consider an example. Say, you bought two lots of a commodity at ₹4 lakh. The price fell 10 per cent and you purchase an additional lot. If the price slides another 5 per cent, then your loss will be higher by ₹9,000 due to averaging.
Averaging has been used by many investors with a fair degree of success, but the benefits in trading are doubtful. There are many reasons for this. One, since investors have a larger horizon, they can average over a period of a month, if needed. They have the luxury of having more than two years to recover their loss and making profit. Traders, on the other hand, have a very small window, sometimes just a day. Averaging is dangerous with such small time-frames. In trading, averaging is compared to catching a falling knife; the chances of getting hurt are high.
Two, fundamentals play a greater part in investing and chances of the averaging strategy succeeding are higher if you have firm belief in the fundamentals of the asset. Three, capital erosion can be borne more easily by investors compared to traders.
Instead of trying to average a position and make it profitable, it makes better sense for a trader to just close a loss-making position once the stop loss is hit and shift to another counter.
A better trading strategy for traders is pyramiding. Here, you have to keep adding to your profit making positions instead of the loss making ones. The first position has to be the biggest. Say, you buy five lots first. If the price moves 2 per cent higher, buy two more lots. On further 2 per cent increase, buy one extra lot. This way, when you finally pocket the gain, it will be much larger.
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