By Fernando Gonzalez, developer of Online Trading Academy’s original curriculum*
Posted: May 25, 2007

In Jack Schwager's popular book, Market Wizards (a compilation of interviews with top traders), a common theme runs throughout nearly every interview: That much of what is successful trading can be attributed to good risk management. Anyone who has traded would know this to be true. In fact, we can even go so far as to say that the proper management of risks is the difference between success and failure, no matter what system or style is employed.

Those of you who have survived many years actively participating in the markets will know this to be true as well. Our success or failure as traders is defined by the day, and because we are trading a market constantly in motion, the constant management of our exposure to the risks that come with those motions through time is what ultimately determines our survival.

As time goes by, our trading styles and technical strategies will change as dictated by the market's trends and our own experience, but a proper risk management system can be applied from the beginning all the way through to the end.

This topic of risk management covers a very wide array of sub-topics. And, while we don't have room to discuss them all at once in this article, we will focus on a very common risk management "sin" among traders: Averaging down.

For those of you who aren't familiar with this term, "averaging down" is the act of adding to an existing position. It has a very negative connotation in the trading community. This is because averaging down on a trade usually happens when a trader is in a losing position: Rather than getting out of that position at his or her intended stop loss point, the trader will override the original plan and, instead, ADD to the position, to lower his or her average entry cost by adding to the position at a lower price.

The psychology behind averaging down is driven by the fact that the market now doesn't have to "bounce" back too far in order to bring the trader back to a "flat" or "safe" price position.

From the viewpoint of a bystander, averaging down is a tough bet to take because, in the process of trying to get "safe", the trader will assume a greater amount of risk (against a market that has already been telling the trader, by moving against him or her, that the trader was wrong in the first place).

To challenge the market is not a very smart thing to do; it is infinitely bigger and stronger than we are. We traders are just "Davids", and the market is "Goliath." And, while the story says David will win, allow me to humbly assure you that, in the stock market, Goliath always wins.

You see: We have to love and "listen to" our losers. They are the market's way of telling us we are wrong. Some will listen, but, unfortunately, most will not. This is not because people are inherently hard-headed. It's because most of us are wired from childhood to "never give up." And, so, when we get into losing positions, our innate tendency is to "not give up" by adding to our losing trades. This, of course, just perpetuates a very clear mistake.

But, when you choose to participate in the markets, you have to learn that "giving up" is an elegant thing to do. In fact, it's a significant part of the game, somewhat like poker, where "folding" is part of a larger, overall strategy. To survive the markets, we have to go through the process of undoing a lot of our innate tendencies and think in the opposite direction. To "fold" when it's time to fold, rather than try to play hero. In the markets, a thousand dead heroes abound for every one who's still around.

When we override our intended stop loss point and add to the losing position, we put ourselves in a position to make a series of mistakes that could be catastrophic now. Or, if not now, then, in the future. By averaging down, we challenge the market's signal that we are wrong.

Rather, we need to listen and adjust to it by "folding" and coming back with a new strategy. While averaging down will save you on some occasions, it is what ultimately destroys most traders.

In fact, a trader who has a habit of "averaging up" (adding to a winning position) is likely to survive longer than a trader who has the habit of averaging down. Think about it.

"Good" Averaging and "Bad" Averaging

In my risk management lectures, the topic of averaging down often comes up in the discussion. And, while I advise my students against averaging down, I make a critical distinction. You see, there is "good" averaging down and "bad" averaging down.

"Bad" averaging is exactly what we discussed previously in this article: It’s the act of overriding an original stop loss point (changing the original plan) and, instead, adding to the losing position to lower the cost average closer to a perceived "safety" in price.

"Good" averaging, on the other hand, is when the position added is part of the trader's original plan to distribute risk. By dividing his or her default position size, the trader develops a plan, well before the trades, to enter the market in at least two separate locations.

This can be planned either way the market goes (up or down). And, in the process of planning entries, he or she also develops the areas at which this person will stop out his or her positions. By varying the entry and exit points (in both price and time), the trader is able to distribute his or her risk across a range in the market's motions in order to capitalize on what the trader expects to be a sustainable trend out of a particular range in time and price.

In the process, the trader is able to minimize risk versus selecting one particular entry and, thus, focusing all risk in one singular spot. This is even more applicable in volatile markets. So, planning different entry points for a trade is part of a larger overall strategy in risk management.

"Averaging down" is not all bad. We just have to distinguish between "good" and "bad" averaging. And, the difference between the two lies in whether the follow-up entries were pre-planned or not.

*Reprinted (and modified) with permission from Online Trading Academy www.onlinetradingacademy.com