Stocks are mixed this afternoon ahead of another busy earnings schedule after the close. I sent out my watchlist to clients last night, some of the names I’m watching this week include YEXT, TWTR, and BOOM.

That said, there are distinct setups that I’m always on the lookout for, they include the rounded bottom breakout and pinball setups (I’ll cover in another lesson).

I stick to just a few setups because they are the ones I’ve found to work. Furthermore, when it comes to my trading indicators, I keep those simple too.

That said, I put my plan together (my emphasis is always on capital preservation and risk management), and then I wait for my setup and trade my plan… that’s it… nothing more…nothing less.

For example:

trade the plan

Trade the plan…

 

Every trade has its plan. That said, it’s either going to make money or lose. The key is to be prepared for both outcomes and stick to the plan.

(It’s all about risk management, and striving for consistent base-hits, if you’re ready to start trading with me, click here to get started.)

Let’s face it, no one has a crystal ball. Stocks can go up and they can go down. And the market can stay irrational longer than you can stay solvent. If I’m wrong on a trade, that’s it, I take my licks and keep it moving.

However, I often hear stories of traders who fall in love with their trades. When their position moves against them, they are eager to add to a losing position in the sake of “improving their price.”

(Legendary investor, Paul Tudor Jones, set a reminder at his desk about averaging down)

So why am I so against averaging down? And what can you do to avoid being “a bag holder?”

 

Averaging Down Could Ruin Your Trading Account

 

So many traders have asked me, “What’s your take on averaging down, and should I do it?”

What’s common between all the traders that have asked me that question is the fact they’re stuck with the bag. In other words, they’re stuck with a losing position that they have already doubled or tripled down on… by the time they talk to me.

First things first… I never average down.

You see, when you average down on a position, you’re buying a falling stock. In other words, you’re buying more shares after the stock has fallen in order to get a “better” average price.in hopes of it reversing… thinking you would make all your losses back, and then some. Chances are, you’ll end up taking a big loss when you double, triple, or quadruple down on your position.

 

The Psychology of Dollar-Cost Averaging

 

I get it, sometimes it’s hard to take losses. However, it’s all part of the trading game. When you’re losing on a trade… it’s okay to get out. You can always get back in just for another fee, if you see one of your winning setups.

Now I stress this because many traders like to think, “I didn’t realize the loss yet… so technically, I didn’t lose money yet.” Just because you are still holding onto a position… it does not mean it is not a loss.

What tends to happen when traders have this mentality is they get into all sorts of trouble. They’ll hold onto the loss, buy some more shares… only to see the stock fall… and then buy some more shares… and at some point, they’ll book a massive loss. This happens a lot with small caps due to the volatility they have, and sometimes… the sell offs in these stocks can last a while.

If you’re in this boat, there is actually a quick fix. Now, I like to give myself guidelines on preventing the “need” to average down.

 

Never Average Down

 

One of my golden rules is to never risk more than 2% of your overall portfolio on any single trade. In other words, let’s say you have a $10K account, you would not want to risk more than $200 on a trade. That way, you’re able to stick to your trading plan, have proper stops in place… and it’ll give you some room for error.

When you don’t trade with risk limits… you could get caught in one of those averaging-down bag holder positions… which could really ruin your account.

Let’s say you have 5 positions on… and you’re down near 2% on two of your trades… flat on two of your trades… and down 1% on one of your trades. What many beginner traders would start doing is add to those positions in an attempt to make up for losses. Rather than piling on the risk on multiple positions… I encourage traders to manage the trades they already have on.

When you start to pile on risk, it’s not hard to lose 25% of your account quickly.

Now, you might be wondering, “Petra, is there any scenario you would average down in a position?”

Well, let’s say I’m long a stock, and get caught in some news… and the stock gaps down. The only way I will add to that position is if the stock begins to show me a move back up… and the technicals confirm that. However, if I do add to the position, I will immediately put a stop in on the price I added at breakeven. That way, I do not increase my losses if the stock reverses and starts to fall.

If you’d like to learn more about my approach and my do’s and don’ts, make sure to check out My Top 10 Trading Tips.