#1: Don’t Average Down
Averaging down — or adding to a losing position to reduce your average cost — is one of the most destructive actions a trader can take. For one, it works in direct violation of the first rule of trading: cutting your losses quickly. But even more important are two aspects that underlie the psychology of averaging down.
First is that the strategy probably works about 25% of the time — just enough to provide a trader with memories such as, “What about that time I doubled down on Cisco Systems (NASDAQ:CSCO) and it came back, and I got out of the position even?” Unfortunately, it also fails 75% of the time — creating trading black holes that can lead to serious wealth destruction and far outweigh the benefits of the times when it worked.
Second is the temptation of reducing your average cost on a losing trade. If you’re in a bad trade with an average cost of, say, $20 with the stock at $18.80, that $1.20 might seem impossible to make up. By simply doubling down, you can bring your cost all the way down to $19.40 and cut the gap to 60 cents. That’s a shortfall that seems much easier to overcome, and it helps ease the psychological pain of the bad trade. More often than not though, it leaves the trader in an even bigger hole than before.