Stay Away From This Trading Behavior
The Dynamic Wealth Report
October 21, 2009
by Justin Bennett, Editor
Think of a bad behavior.
Texting while driving comes to mind.
I risk sounding like your mom for bringing this up. But texting while
driving has got to be one of the most irresponsible things I’ve ever
seen.
You’re focusing your attention on a tiny keypad instead of the road? Now
you’re driving a vehicle like a baboon in a circus car. Paying no
attention to what, or who, lies in your path. Incredibly irresponsible
if you ask me.
Officials say texting while driving is just as dangerous as drunk
driving… if not more so.
Now, let me get off my bad driving behavior soapbox and jump onto my bad
trading behavior soapbox…
One of the worst trading behaviors is called averaging down.
Averaging down is entering a trade because you think a stock is "cheap" (or some other fundamental reason) and buying more as the price goes
down. It’s basically saying, “I’m not really sure what’s going to happen
but it looks “cheap” here. If it goes down, I’ll buy some more.”
You may ask, “Why is that such a big deal?”
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It’s a big deal because the market can price your stock at “irrational
prices” longer than you can stay solvent. You’ll get to a point where
the loss will be larger than you can handle.
Take a look at this chart. It’s what the average trader may think as a
stock price falls.
Transocean (RIG) is a premier offshore oil driller. Major oil companies
contract them to bring up oil from deep beneath the sea. Net income went
from $1.3 billion in 2006 to over $4.2 billion in 2008 - A jump of 223%.
RIG was in a high demand industry with oil trading at $147 a barrel. The
world needed more oil and RIG knew how to get it. When RIG pulled back
to $120 from its high of $160, many thought this was a chance to get in
“cheap”.
As you know, in 2008 we started into a recession and soon after a
financial meltdown. In the second half of 2008, RIG started getting
really fundamentally “cheap”. Amateur traders kept buying. Pretty soon
it was apparent that the economy was in big trouble.
What do they do now? Buy more? Cross their fingers? Pray?
The trader becomes the investor. He keeps holding the stock trying to
wait out the market. Prime trading opportunities pass him by because his
money is tied up in this “cheap” stock.
By averaging down, you’re breaking one of the cardinal rules of trading.
You’re failing to control your downside risk. Never let a losing trade
turn into a long term investment. Always have an exit point for every
trade.
A stock may be cheap by your metrics (RIG was no doubt fundamentally
cheap), but ultimately the market is always right. It can value the stock
wherever it pleases and keep it there for longer than you can stand.
And
there’s nothing you can do about it.
The only time averaging down is acceptable is when you plan it at the
beginning of the trade.
Professional traders can average down and get away with it. They
understand the concept of risk control.
A professional may sound like this, “I’m going to buy 200 shares at $120
and 200 shares at $118 for a total risk of $800. I’ll have a stop loss
at $117 if I’m wrong.” Professionals can control the downside risk by
predetermining their exit point.
Most amateur traders don’t do it that way. They just keep buying because
it’s “cheap”.
Averaging down in trading is the equivalent of texting while driving.
You’re setting yourself up for a big disaster if you do it. You could
literally wipe away a huge chunk of your portfolio under certain
circumstances.
Never average down into a losing position without a plan to exit!
• Silver (Over $17.50 an ounce)
Precious metals continue to climb. Silver is sometimes called the “Poor
Man's Gold”. If precious metals continue to climb, expect Silver to
outperform Gold on a percentage basis.
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