By Jeff Clark, editor, Delta Report
Editor's note: Today's essay comes from our friend and colleague Jeff Clark, one of the best traders we know. Over the last decade, he’s delivered 28 triple-digit winners and 78 double-digit windfalls for his readers.
Below, Jeff discusses one of the costliest mistakes he's come across in his 35 years of trading. As you'll see, this is a popular strategy that you should almost always avoid. If you don’t know what you’re doing, it can wipe out your entire portfolio…
It took Martin just a few months to blow up his entire account.
In mid-2001, Martin bought 1,000 shares of Polaroid Corporation at $10 apiece.
The company had fallen on tough times. The stock had already plunged more than 50% on the year. But Martin was convinced it would turn around.
“Blue-chip stocks don't just all of a sudden go out of business,” he said.
The stock dropped to $8. And Martin bought 1,000 more shares.
“It's a steal at this price,” he said.
Polaroid then fell to $5 per share.
“I'm not worried about it,” Martin claimed. “I've done the math. All I need to do is buy 2,000 shares here at $5. Then when it pops back up to $7, I can sell everything and break even.”
You can probably guess what happened… The stock didn't pop up to $7. Instead, it fell to $2. And that's when Martin got aggressive. He bought 20,000 more shares.
“My average price is now less than $3 per share. I'll make a killing when this thing bounces.”
The problem was… Polaroid never bounced. A few days later, it traded for $1.
Martin was desperate. He had “averaged down” on a bad trade. This one stock now made up most of his account. And it was sinking… fast.
Martin started scribbling out another order ticket. Most of the traders around Martin thought he would finally bail out of the trade. He'd sell Polaroid for whatever he could get, lick his wounds, and then move on to getting his account back up.
But that's not what Martin did. Instead, he filled out an order to buy another 30,000 shares of Polaroid at $1.
“What else can I do?” Martin explained as he handed his order to the trading desk.
Under his breath, another trader whispered, “You could pray the stock drops to $0.10. Then you can buy a ton and really bring down your average cost.”
Less than one week later, Polaroid stopped trading at $0.28 per share. The company declared bankruptcy. The stock never opened for trading again.
Martin had blown up his entire account.
But at least he only lost an average of $1.81 per share.
“Averaging down” on a losing position is almost never a good idea.
The only time it makes sense is when you make it a part of your strategy from the beginning… like if you take a smaller-than-normal position, expecting to be early on the trade. That would give you some flexibility to slowly build the position to a normal size.
That's the only time I average down.
Every other time leads to traders taking on too big of a position. They get overleveraged. They get committed. Then they get emotional – which creates another set of problems.
When there's too much money at stake, traders tend to make bad decisions. They don't sleep. They eat poorly. They go to the bar after work.
None of that leads to good trading.
Also, traders should never average down when buying options. As time passes, the price of an option falls. Time works against you.
In my early years of trading, I flushed so much money down the toilet trying to turn a profit by averaging down on options trades. It would work, maybe, 10% of the time… But 90% of the time, I would quickly regret that decision.
Leveraged funds fall into the same category.
Most leveraged funds use futures and/or options contracts to double or triple the returns on their respective benchmarks. Like with options, time works against them.
Some traders will argue that averaging down on individual stocks is different.
Remember what Martin said: “Blue-chip stocks don't just all of a sudden go out of business.”
By averaging down, these traders say, you can bring down your cost basis and make it easier to turn a profit on the trade.
But if you average down and buy more shares of a losing trade, you run the risk of exponentially increasing your losses. Even worse, you run the chance of getting emotional on the trade and hanging on “no matter what.”
That usually doesn't work out well.
Just ask Martin.
Best regards and good trading,
P.S. For the past six months or so, I've been refining what I consider the single best idea I've come up with in three decades of trading. I've tested this idea with my own money on 35 trades… and have averaged 50.14% gains. I'm nearing the finish line.
If you'd like to receive updates on this project, as well as my morning market commentary, the Market Minute, click here and you’ll automatically be added to my list.