The Averaging down strategy is based on adding to a losing position but reducing the price at which a bounce-back returns a profit. Thus, when adding to a losing position, you can get a better average price, i.e. the loss on the aggregate position is reduced and after the price rebounds you can average your trade to zero profit or even make some profit from the trade. Simply put, when the first order is losing, you open the second position to compensate for the losses in the first transaction, but also for the spread and other commission fees paid to the broker. Since the total price of two open positions is averaged, this method is called the “averaging down” strategy.
The averaging down method works well in any conditions, on any timeframes, and it can be incorporated into any trading strategy and trading approach. In a way, this strategy may serve as the alternative to StopLoss, it is similar to the Martingale system
Let’s look at an example of how this averaging down strategy works. So, we buy an asset at 1.5500. When the price reaches 1.5400 the trader decides to open another position of the same volume in the same direction. The calculation of the average purchase price would be as follows: (1.5500 + 1.5400) / 2 = 1.5450, i.e., having reached this mark, the trade will be closed.
This way, when closing the position we achieved a nice breakeven. If we placed the second order with a larger volume than the first one, then: volume1 = 1, volume2 = 2, Volume1+Volume2 = 3, (volume1 / Volume1+Volume2) * 1.5500 + (volume2 / Volume1+Volume2) * 1.5400 = 0.5333 + 1.02 = 1.5533 the average purchase price would be even lower. If you catch the right moment during the rebound, you’ll manage to close your trade even sooner. That is, the higher the volume of the “added position”, the faster your order will be closed.
Averaging down: pros and cons
To tell you the truth, there are more disadvantages to this method, than advantages. The main benefit of this strategy is that the trader gets the opportunity to exit losing trades with a more or less favorable result and has a chance to save his money. It is important to note that the “opportunity” doesn’t mean the “guarantee”. The method isn’t 100% and won’t save you from the losses. Which is its first drawback.
Let’s take a look at other disadvantages of the Averaging down strategy. If we go back to our previous example we may think – everything looks easy peasy. You just open an additional transaction and end up closing a profitable trade. In reality, you may be faced with a number of difficulties. The most important thing is that no one knows how long the price will be moving in the wrong direction. So, it may be difficult to decide when to place a second trade. If we hurry and do it too soon, we’ll now have two losing trades. And if we take into account that the second trade is bigger in size, then our total loss becomes even more significant. As a result, our floating loss will increase with each new trade and with the further decline of the pair. In this case, the risk/estimated profit ratio isn’t equal.
The solution here is to use indicators that show the change of trend. For example, you can use oscillators and open trades in overbought and oversold zones. Another recommendation is to trade on a cent account. This will give you more room for maneuver, although your profit and trading result will much more modest.
Averaging down method may be useful for traders with:
- sufficient trading experience;
- ability to determine the beginning and the end of the trend;
- the ability to spot correction and determine the duration of the trend.
All in all, if a trader already possesses these skills, he can successfully trade without having to use the averaging down strategy at all.