You may have heard advice from someone – a relative most likely – to average down for a better price. “If you liked it a X price, why wouldn’t you like it at Y price?” This might be sound advice for an investment… but poor advice for traders. The following is a beginner’s guide to the basic differences of dollar cost averaging and buying dips, depending on whether you are a trader or investor.
Averaging down in a bull market, when someone is committed to holding an asset for five to ten years, is a sound practice. In that scenario you have to remain long-term bullish on the fundamentals of the asset. Generally, that means putting in the research, understanding the balance sheet or technology, the use cases or application of the technology, and fully believing in the long term potential.
However, if you're a trader, you want to be taking advantage of the shorter time-frame movement in price action. That means you are looking to capitalize on the fluctuations between the highs and the lows of an asset's price. But if are constantly only buying lower prices, then you are (potentially) only digging your trading position deeper into a hole that will eventually become too much to bear. By averaging down only, with a short timeframe mindset, then you are allowing your long-term bias to influence your shorter timeframe trading. This opens yourself up to all sorts of psychological and financial ramifications, including depression, regret, and deeply under-water positions leading to serious losses.
As a trader, if you find yourself continually averaging down, then you have yet to separate yourself into the Trader or Investor category. Investors do not care about price declines or bear markets, they buy the long-term potential no matter what the market is doing. But if you're a trader, and you're averaging down, then something is wrong with your trading approach. Let’s start with some of the basics that you are not implementing.
- Identify the dominant trend.
- Identify an appropriate entry point.
- Protect capital with stop losses.
Take heart though my friends, these are all correctable mistakes. If you have heard of averaging down, then you have likely heard of the oldest cliché, “Buy Low, Sell High.” It sounds so simple, and in a way, it is, but it requires a lot of work and self-discipline to execute that strategy.
To be clear though, buying the dips and scaling in to positions are very different than averaging down. Buying a dip means you are buying at a logical low point in price during an established UPTREND.
(Bitcoin in 2017.)
A potential Moving Average strategy. You might ask, how would someone know to buy those areas? Only the third drop touched a moving average? Let’s take a step back and switch from a daily chart to the weekly (below). Three distinct dips where you could have bought the bounce and traded the minor bull moves.
(Same calendar time frame, but a weekly chart.)
Those two initial dips both touched the 20SMA on the weekly, or the Middle Bollinger Band (MBB). This is why we look at the larger time frames for the dominant trend.
Breaking up position size is also different than averaging down. Only once you have spotted an ideal entry, you execute a trade (entry tactics are a much more nuanced conversation). Let’s say you have a $10,000 portfolio. A normal position would be $1,000, but that also depends upon how far away your stop is from the entry. IF the entry is a little more risky, you can nibble around the edges with half a position ($500) and wait for price confirmation to enter the other half. That way you limit your risk exposure. (We will dive into this in a future discussion)
With both of the above notes, YOU ALWAYS USE A STOP LOSS. General guidelines are that you never risk more than 1% of trading capital (That $10k portfolio means $100 is the most you can lose on a trade) and find the appropriate stop loss point corresponding to the 1% risk. If you have identified a good Risk/Reward, then the stop point shouldn’t be far from your entry. Example: If your profit target is $1.50 from current price, your stop should be less than $.50 from the current price.
There are three main points we evaluate for our buys:
- Pattern or Trend (we have to make sure there is an established trend)
- Intensity - how strong is the movement (technical indicators)
- Risk/Reward – is the reward at least 3/1 in your favor.
Next, we look at entry and exit points. We do not make an entry before performing the three checks above and same applies to exiting the position! Seriously, you went to all that work to figure out the ideal entry and your stop loss. You have to consider where you will be taking profit.
The next time you get stuck holding losses in a declining asset or the low you bought didn't hold, learn to exit immediately and minimize your losses.
(Bitcoin 2018 bear market)
Averaging down for investors is a great way to capture the major multi-year advances in an asset. But for traders, averaging down is not a sound practice because it works on the assumption that an asset is continually going up. A trader must remain agnostic to price direction, and be focused purely on trend, whether that is up or down. Once you remove your emotion and bias from your trading, you can begin to clearly see the trend and trade with its direction.
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