In today’s episode, you’ll discover how to average into your losers (without committing financial suicide).
So listen to it now…
Hey, hey, what’s up my friend?
In today’s episode, I want to talk about how to average into your losses. For those of you who are not familiar with what that means, it means that as the market moves against you, you continue to buy even more.
Let’s say you buy a stock at $20. Then when the market drops, the stock price is now trading at $10, you buy even more stocks at $10. You can see that as the market goes against you, you’re buying even more.
This is what I mean by averaging into your losses. Your first position is in a loss, and you buy even more as it continues to move against you.
Before we talk about how to do it, first and foremost, I want to share how not to do it…
Avoid this huge mistake most traders make
Most traders average into their losses based on emotions or without a plan. They want to average into their losses because they think that as the market makes a slight bounce, they could get out at a much better price and breakeven.
Let’s say you bought 1,000 shares of stock A at $20. Then its price collapsed to $10 and you bought another 1,000 shares. At this point, you have 2,000 shares of this stock A.
However, if stock A now were to rebound from $10 to $15, you’ll be able to get out at breakeven. If you did not average into your losses, then the stock price would have to go from $10 to $20, then you can get out at breakeven.
But if you average into your losses, you can see that you could get out at breakeven at a much lower price of $15. If you do the math, you’ll see that it’s true. But the problem with averaging into your losses is that if you do it without a plan or proper risk management, you could lose more than intended.
Initially, you bought 1,000 shares at $20. Then you average in another 1,000 shares at $10. If you think about this, now you’re controlling 2,000 shares. If the market doesn’t bounce higher but instead continue to move against you, your losses are amplified further.
That’s something very important that you must be aware of. Averaging into losses is financial suicide, if you have no idea what you’re doing, or if you’re trading based on emotions.
Now the question is, when should you average into your losers? And how do you do it? Well, there are three circumstances which you should average into your losers.
(Before that, you’ve got to understand and manage your risk. You must know how much you can potentially lose before you consider averaging into your losses.)
Circumstance #1: Taking advantage of a crisis-opportunity
Take for now, we have the COVID crisis where a lot of asset prices around the world are plummeting like a rock. Oil, for example, is now trading about $25.
If you think about this, oil cannot stay this low forever because once demand comes back, demand for oil will go up. Right now it’s about $25 and I have no idea where the bottom is. I can’t predict how low oil can go.
What I could do is, let’s say I want to buy some oil with $50,000 in capital to take advantage of this opportunity. But since I have no idea how low oil could go, I could put in the first $25,000 at when oil is trading at $25.
And if let’s say oil dropped to $10, I can put in the remaining $25,000 to buy oil at $10. We can see that from the start, I’m prepared to risk a fixed amount of money on oil. It’s all part of the plan.
I’m not gambling or trading based on emotions. I’m prepared to set aside this amount of money to invest in oil. When there’s crisis opportunity and you have no idea where the bottom is, you can enter in trenches.
For example, after the asset dropped 40%, you enter one time, and then when it dropped 60%, you’ll enter for a second time.
(But before we can even execute this, you have to know how much money you’re willing to risk.)
Circumstance #2: When the price is at an area of value
The area of value could be support resistance, trendlines, moving averages, whatsoever. This area of value can be very wide.
Let’s say you’re about to buy some Amazon stocks and it’s coming into an area of support. However, the area of support is not at a clear cut price level at $100. Maybe the area of support is between $120 and $100. It’s a $20 area and you have no idea where Amazon is going to find support.
Let’s say Amazon comes to $120 and you don’t miss the move. You can buy a certain amount of shares at $120. Then if Amazon continues further down to $100 you can average into your losses and continue buying Amazon because it’s coming to this area of support.
However, for trading, you have to know when to cut loss. Eventually, the price could just smash through support and go even lower. You must have a pre-determined point to exit the trade.
Let’s say $90 is a point where it’s your last line of defence. Then when Amazon reaches that price point, you’ll exit all your positions. In this case, you’re trading an area of support, but because support is a wide area, you can average into your losses as the price continues to move against you.
But again, you must have risk management in place and know at what point to cut all your losses. For example, let’s say you are used to, risking 1% on each trade. If Amazon first comes to the $120 level, you could risk 0.5% with a stop loss at $90.
And if Amazon comes to $100, you can risk the remaining 0.5% and your stop loss still in $90. In this case, if you get stopped out, the total loss to your account is only 1%. Does it make sense?
Circumstance #3: Dollar cost averaging
This is a very popular term in investing. What you do is that every month, you buy X dollars of an asset like the S&P 500 index’s ETF called SPY. Let’s say you have no idea, where is the top or the bottom.
So every month, what you want to do is to simply dollar cost average into the SPY. Let’s say you can buy $1,000 of SPY every month. Regardless of whether the price goes up or goes down, you’ll just average into that asset.
What this does is that you’ll get the average price of the SPY over the long run. In a bull market you’ll buy less, but in a bear market when prices are low, you’ll buy more.
This is a kind of systematic way to invest in the US stock markets. Dollar cost averaging is kind of similar to averaging into your losses, especially when we are now in a bear market.
I hope that makes sense and with that said, I’ve come towards the end of today’s episode and I’ll talk to you soon.