THE CONCEPT OF AVERAGING :)

Pardon me for stepping a little off track. The blog is about market views and not trading strategies but since a reader has expressed his ideas about the concept of averaging I also would like to share my own :)

A technical trader buys a stock for 2 reasons :

1) The stock is trading close to its important historical supports. 200 dema is considered to be a very good level for Long term investors to enter.

2) The stock has given a breakout out of its range or a technical pattern pointing to a quick move on either side.

STRATEGY 1

The advantage of strategy 1 is that the risk reward at important supports is very favourable.Hence you can come out as a winner with a average strike rate of say even 40%. Say the risk reward per trade is 1:3 ( the distance between the entry price and target is 3 times the distance between entry price and the stoploss ) In this case for every three wrong trades you just need one right trade and you protect your capital. 

The disadvantage of Strategy 1 is the time involved.When a stock comes near important supports it takes time to resume its upward journey. It does so slowly and steadily. Offcourse we do see sharp bounces, but those are only after sharp falls. Lets stick to normal events for this discussion.

The time involved can also be estimated by certain technical tools like Gann Analysis or Elliot wave, but very few technical analysts use these tools for short term calls.Moreover, they aren't so easy to understand.

STRATEGY 2

The advantage of Startegy 2 is that the stock moves fast. Either ways! Its hit out or get out. Traders as a breed are impatient and prefer breakout trades.The verdict is out in 4-5 sessions. If stock stays sideways a momentum trader hits the time stop loss ( When stock does not erupt according to the preceding pattern as expected within the intended holding period, you hit the time stop loss : a term known only to the seasoned players )

The disadvantage here is the risk reward is deep, often 1:2 maximum. Also the spikes are sharp and breakout trades involves more retail participation.Everybody knows when a stock breaks out! Recent example : Great Eastern Shipping gave a false breakout of 330 and crumbled hitting many stop losses!

WHY AM I SPEAKING ABOUT TRADING STRATEGIES, LOSING FOCUS FROM AVERAGING ?

Certainly not. This is just to provide a context. Now we speak about the concept of Averaging. A breakout trader can choose to average if he wishes to keep his risk reward low.The view on the stock remains the same till it hits the stop loss. Then why not average on dips to improve the risk reward, not because you are stuck in a losing position. Secondly, a support trader can choose to average after he has formed a view that a particular support will hold (as long as the price is above that).

Averaging in common trading parlance means adding more to a losing position which normally most of the traders do. But averaging in a different and more sophisticated context means buying your stock in bits and pieces when your opinion is that the stock has bottomed out fundamentally and technically. (Case in point : Sugar stocks may bottom out soon)

So averaging is not for losers as long as the intent to average is clearly defined. :)

Regards,

Rahul T.