Tuesday, June 16, 2009

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Averaging the Buy Price to Minimize Risk: A Common Mistake of Stock Traders

This is something that almost every trader or investor does in his own trading at one point of time or another. I did this myself several times and had to learn the bitter lesson before stopping it. There are several bad consequences that averaging the buy price results in. Typically we tend to think that the risk in a falling stock will be minimized if we buy more quantity of the same stock at lower prices because that brings down our average buy price.

averaging the buy price to minimize risk in stocksImage Source

My Personal Experience with Averaging Buy Price

Let me explain the situation with an example so that even if you haven’t done this before you can learn to avoid it in the future. There is a stock called CMC that I bought two years back when it was flying high. I missed its ride all of the time because I never tracked it before. It was just the time when I learned about chart patterns of stocks that make new highs and keep going higher.

The common of such stock chart patterns is the cup and handle pattern. It is nothing but the chart of the stock’s historical price movement looks like a cup (stretched U shapre) and after the top of the cup continues the same price for some more time to form the handle shape. This is found commonly in many stocks that make such exotic moves in a range trading market. The pattern lasts about 4-8 months only.

Having learned somewhere that following these patterns will help us take advantage of biggest gains the stock can in only a short period of time (about 2-3 months), I had set out to apply this in my own trading. As I started looking for such stocks studying their charts at bseindia.com, I found that this stock was just doing that. Please note that this stock was already in the list of some stocks that I used to track regularly. Otherwise I would have caught even better ones probably.

The chart of CMC has just confirmed that it fit the cup and handle pattern. But what I missed to see was that it was already in the process of making its dramatic expected move upwards. I should have found it a little earlier. Or I should have waited for more time. Thinking that these stocks repeat such movements again and again, I just entered it at 1300 when it was falling from its high of 1500.

The next day it fell down again and then it continued slide everyday. One day after touching 1150 (which I guessed rightly out of gut feeling), it made a quick bounce till only 1250. It stayed there for quite a time when I grabbed more in 2:1 ratio of existing stock to bring down the average buy price. I bought it at 1180. The average came down to 1225.

Unfortunately the stock did not make any more upmove other than going till 1265. I felt that if I close the trade at 1250 I would just close it without loss after adjusting for brokerage charges. I thought it was such a stock that I can wait even it were to fall further for some time.

Just look at this situation. My bet had gone wrong in the first place. I did a good thing to first guess the reversal or bouncing point and bought in 2:1 ratio. But I did not close the trade to avoid loss but rather desired for little more. Unfortunately I did not realize how I would feel when it slides further. It sure slid from there till 1050.

You should have guessed it right this time. I thought of averaging it further by buying more at this price. But I did not do because already it was a heavyweight in my postfolio swinging it the whole postfolio everyday. I realized that now there is no diversification. There does not seem to be hope of it coming back to atleast 1200.

Actually just at the same time, I was also trading a different stock Jet Airways that I bought based on the same chart pattern. At that time it was trying a deal to buy Air Sahara which is a competitor. Luckily I bought this one at a relatively less price (612) after it had fallen from its high of 675. It slid later all the way down to 550 but that did not shake me as much as CMC did. When I closed this it was at 735 just below the highest value it made of 745.

I couldn’t get the same thing with CMC. Because I had made a profit on a similar stock, I felt it too would show its move soon. I was missing to see why this along with others in the same industry is falling at the same time. By the time I realized this it was too late. The stock started falling further and swallowed all the profits I made earlier with the right bets. At last I made the decision to close the stock.

But I did not close it in haste. Because I had such experience before in a different stock. I learned a lesson from those earlier wrong gone bets that immediately after I sold them they made a little move up that would have offset some of the losses. So I waited as the stock bounced again.

A Bad Closing!

Unexpectedly the stock bounced all the way upto 1650 in only three days of time. I was wonderstruck and did not understand all this. I was thinking that the stock was doing another cup and handle pattern. The next day it fell down to 1450 again. Then to 1350 and so on. I just watched it thinking that I can sell it again in its next move.

As the fate would have it, it fell down below 1100. This gave me such a bad feeling because I felt like a toy in the hands of the stock that is moving on its own without any sense. I did not understand what I was missing. Eventually I closed the stock when it made its last bounce at 1125. The stock this time went all the way down to 900.

Lessons from This Mistake

The biggest lesson I had learned from this is that averaging did not bring my loss down. In percentage terms, yes it did. But as percentage of loss on my total portfolio value, it had done worse. I would have had a lot lesser loss had I instead sold at the same price I bought for averaging.

It was plainly simple. Don’t put good money in the bad stock. Let it slide. Cut your losses if possible. Or wait for a small bounce and close the trade. But don’t add to the bleeding. It results in a wound that is exaggerated by the first aid.

The other lessons too are important to consider. I was not able to stick to my plans all of the time. I was changing plans with each transaction or each time the stock made a reversal move. When it made a bounce I was thinking about selling it for a little higher price. When it was falling down further, I felt I could have closed it just a day before. Then I make plan to sell it if just goes above from there by 2%.

When it eventually made a run away completely unexpected, I was wonderstuck when I had to be quick to run away with the gold that was somehow thrown at me. I realized that apart from heavy influence the averaging effect can have on our portfolio, when combined with our discipline in trading, the matter only got worse.

Had I thought in the same way at the time I finally closed the trade, I would have seen a big hole in my portfolio. Atleast in the end I closed it in a smart way. But it left a bad feeling because I held the stock for 6 months without any returns but only considerable loss that wiped out the gains made by two other successful trades which took only 45 days. I couldn’t bet on anymore stocks during the rest of the time because I was heavily bought in the name of averaging.

Avoiding Averaging Helps Later Trades

I had learned a good lesson from this. From then on whenever my bets went wrong, I had either cut the losses short or held my breath but never added more money into it. Why put good money for the bad? This principle really helped me as I made the biggest strides by betting on the next good bets like RNRL, ELECON ENGG, GMRINFRA, and so on. At the same time I had seen some trading friends who couldn’t move fast in pace with me because they still had some bets that they made worse with averaging.

When a stock goes in unexpected direction, just hold yourself. Control the urge to turn it around by thinking about how worse it can get if the stock goes down further. The only way it can get better is if the stock makes a turn around. But then of course you will definitely feel that averaging would help you make much more.

The reality is not so simple. Most of the times a stock that goes wrong, continues to do so. Just because you saw some cases where this was not true, and also found the reason that averaging will give more advantage if the stock turned around, does not mean you should risk too much every time. This is like a double edged sword. The risk or reward increases once you increase the exposure to the same stock.

If the stock were to turn around, then you would certainly be able to find a different stock that would also make its best move. The key is to avoid regrets. If you cut the loss short it gives you a good feeling which helps you spot next best opportunity. It often happens that once you have a bad experience in a certain stock, you will continue to have more of it if you do more with the same stock. I believe that you too can find similar instances if you go and look into your trading journals!

Averaging is a Mathematical Illusion…

Note that averaging is only a mathematical illusion. You must have known the visual illusion created by certain pictures. Similarly when you do not see some details as to what will happen in the future, how it influences your portfolio etc, this illusion can continue to deteriorate your portfolio while still giving you a false feeling of security.

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