Never add to a losing position: Trading Decision Basics

Jesse Livermore's (Edwin Lefevre pen name) Reminiscences of a Stock Operator is a book about stock trader during the 1920's and 30's. One of the trading principles that he repeated throughout the book is "never add to a losing position." You might think that that there is nothing wrong with "averaging down" on a losing trade. You buy some at 10, and than buy some more as it gets down to 8. Definitely, if for you it was a good buy at 10, it must be a great buy at 8.

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But think about the beauty of Wall Street's ability to get you to average down! They actually make you think your getting a bargain by buying lower! With the idea of a bargain in your head, you don't even consider that you might be totally wrong, and the stock is going down. When you made your first purchase, the broker spent 20 minutes telling you the benefits of this stock. When he calls you to "average down", it's a 30 second sell and he got you to double your position. That second commission is a bonus to the broker for being wrong!

Once you see that "averaging down" was not necessarily a proper trading tactic, you are free to consider that if the trade is going against you, maybe you should get out.

Over time, a trader learns that the market will always be there tomorrow, and that making a fresh decision with no position is usually better. Averaging down will usually conflict with the trading discipline of having a stop loss and profit objective. Good money management will also usually not allow an additional position.

You may often hear people talk about buying at a lower price if the market has gone against them, as it lowers their "average" price. This is total nonsense and is extremely risky. Not only that, but when you add to a trade that is going against you, you are going counter to the trend at that moment. It may well be that the trend has already reversed and by adding to losing trades you may end up with a large position against the trend.

But what about pyramiding a position on a big move? Pyramiding is using profits in a trade to add additional positions. If a position is in a loss, there are no profits to use.

So, the right play here is that if you have a trade that has been going against you and it is clear that you are wrong on the trade, just get out of the market. This leads to taking the occasional small loss, but is not emotionally or financially damaging and leaves your trading capital intact for when the market is right and sets you up nicely to take advantage of the next big move in the market.

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Let's take for example a stock you buy at progressively higher prices, what happens then is you are assuring that your net worth is rising every time you average up as opposed to falling every time you average down. It only makes sense. If you are adding to a winning position, you have momentum on your side and your portfolio value is going higher as a result of the stock going higher. Of course stocks don't go up forever. Eventually all stock prices will reverse and go lower at some point in time. So the last position you buy at progressively higher prices will be a losing trade, but that is the point at which you sell the entire position at a profit.

As long as you buy at higher prices, the market is telling you that you are correct in your analysis and you should continue to trade accordingly. If you buy at progressively lower prices (averaging down), the market is telling you that you are wrong.

Most losing traders have an obsession with being right. They cannot admit they are wrong. If they sell at a loss, they will prove themselves wrong and they cannot or will not admit to that so they hold and hold and even worse, buy more of the same dog stock. It is this stubbornness that ruins many a trader or investor. The successful traders know that being right all the time is impossible. They will easily admit when they got a trade wrong and get out before any real damage is done. Winning traders listen to the market. Losing traders ignore the market. The best advice is to always listen to the market, it may not always be right but it is never wrong.


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