Averaging down means adding more positions in the same direction when a position has unrealized losses.
The word “averaging down” gives the impression of stretching out a losing trade, but do you understand the true meaning of averaging down?
By understanding the difference between “bad” and “tactical” averaging down, the image of averaging down will change.
In this article, we will tell you the meaning of “averaging down,” how to use it effectively in FX trading, and related information.
What can be gained by averaging down in the forex market
In the world of forex trading, averaging down is said to be like the worst example of a trade that should never be done.
Therefore, a beginner forex trader who learns about it may be overwhelmed by the total negativity and avoid even knowing what the purpose of averaging down is.
First, what is averaging down?
Averaging down refers to adding more positions in the same direction when a position has unrealized losses.
For example, you have a buy position at the dollar-yen exchange rate of 101 yen, but the exchange rate keeps falling, so you make averaging down purchases at 99 yen.
If you buy the same amount of currency as the initial position at 99 yen, the average rate of your total dollar/yen position will be 100 yen ((101 yen + 99 yen) / 2 = 100 yen).
Therefore, if you close the trade when the rate rises to 100 yen, you can finish the trade with a plus or minus zero, including the position you bought at 101 yen.
This is called the “averaging down” method: lowering the average exchange rate (average acquisition cost) of the total positions to postpone a loss, and then closing the trade at a loss or even a profit when the exchange rate reverses slightly.
Successful examples of averaging down techniques
Let’s look at a case where averaging down worked very well in FX.
Although unrealized losses continued after the initial buy entry, we repeated the averaging down four times.
As a result, we closed at a much lower rate than the rate of the initial buy position, but we still succeeded in making a profit.
This is the harvest of a reversal by the averaging down method.
The liberating and exciting feeling of going from being in a pinch with unrealized losses at one point to turning around and going from a loss to an unrealized profit.
This appeal of “as long as the rate comes back, I can make a profit or lose money” sweetly tempts the hearts of traders who have unrealized losses.
The Trap Behind the Seemingly Good Forex Averaging Down Method
At first glance, the averaging down method seems to be a good idea, but of course there is a big trap here.
Even if you continue averaging down, if the market continues to fall, you will eventually run out of margin and be forced to cut your losses.
No matter how much you continue averaging down to lower the average acquisition price of your entire position, if the exchange rate does not reverse and rise again, you will have nothing to show for it.
It is fine if the rate returns to the opening price after averaging down, but if it continues to reverse, the unrealized loss will increase by the amount of positions increased by averaging down.
This situation, in which traders continue to do a lot of averaging down with no hope of a reversal, is called “infinite averaging down,” and is a horror story in the FX market that makes traders fearful (see below for details).
People call averaging down a “stupid trade” because of its disastrous and self-inflicted consequences.
About Infinite Averaging Down
Infinite averaging down is the practice of repeatedly and without limit taking more positions in the same direction when you have unrealized losses on your positions.
For example, suppose you have a buy position in FX trading and the exchange rate falls against your will.
By adding to the position by making another buy entry, the average cost of the entire position approaches the current rate, increasing the likelihood that the trade can be closed at the closing price.
In other words, averaging down is the act of risking more money to reduce the likelihood of losing the current trade.
In currency trading, planned and strategic veraging down is not necessarily a bad thing.
However, averaging down for emotional reasons, because one does not want to lose, is extremely dangerous in forex trading.
Infinite averaging down means that the risk of loss is immeasurable, as the position is continually increased by such averaging down without limit.
If the margin runs out, a margin call is applied, and a forced loss cut is made, the FX account will literally go bankrupt and you will be left penniless.
If you look back at the forex chart, you will see a clear trend forming in the opposite direction of your previous position, and you will know that you have been bucking the trend.
How to use averaging down techniques tactically in FX trading
By knowing the characteristics of cases in which averaging down fails, you will be able to take advantage of the benefits of averaging down, which is to take advantage of the average acquisition price.
Nevertheless, what I am about to tell you is not recommended for novice forex traders.
For now, please keep in mind that “there is such a way of entry” as knowledge for the future.
Now, to begin with, unsuccessful averaging down is created by continuing to hold a position against a major trend.
If this is the case, then in this opposite situation, a well-planned entry with good money management will give you the possibility to reap the benefits of the averaging down method.
A situation where you don’t want to grab the high price, but also don’t want to miss it
Suppose you are thinking of making a buy entry at “High A.”
However, if you make a buy entry at this “high A,” there is a risk that you will end up grabbing the high price (i.e., you may be caught in the downward price movement of the push and incur a large unrealized loss).
On the other hand, if you wait and see, the price may continue to rise and you may miss your chance.
What should we do?
If you use averaging down in this situation, there is a possibility that you will be able to hold a position successfully.
Use averaging down techniques in a reversion to the direction of the trend on a large time chart
Let’s review the current market situation.
The trend on the larger time frame is up.
Since the current exchange rate is above the “push low” in this chart as well, we can conclude that the uptrend is continuing and our eyes are on the upside.
*If you are unsure about push lows and upside here, please refer to the following article.
Now, at present, the timing of buy entry is a problem, but by systematically averaging down at this point, we will be able to hold a buy position no matter where the market eventually reverses or resumes its upward movement.
Specifically, anticipate the possibility that the red dotted resistance line at the previous high will roll reversal to support, and first make the first buy entry above that high.
If the price went up starting from that line (the roll-reversed support line), that’s fine.
The position size will be smaller, but you will not miss the opportunity by foregoing it.
Now, if the exchange rate does not reverse at this line and continues to fall, the next step is to do averaging down near the push-low horizontal line.
In this case, the rate was supported by the push-low here and went back up again, so the averaging down was successful.
If the rate breaks below the push-low, it means that the move was not as expected, and we will cut both positions out of the market at a loss.
*If you do not know what a roll reversal or resistance line is, please refer to the following article.
How to make averaging down method work effectively in Forex?
Thus, in order for the averaging down method to be tactically effective in Forex…
- The entry should be in the direction of the trend of the larger time frame.
- The entry point must be a well-founded entry point for a rate reversal against a support or resistance line.
- The planned stop-loss point must be clearly defined.
- Risk management rules for position size and the number of averaging down should be established.
It is very important to thoroughly follow these rules.
Averaging down method that ignores these factors will have disastrous results, as the Japanese market saying goes, “If you are not good at averaging down, you will end up penniless.
The article below describes a real-life case in which a seemingly effective averaging down method was actually fraught with tremendous risk and subsequently developed into a major problem.
Don’t do averaging down to escape anxiety and fear
Emotional jumping to postpone a loss will surely cause you to suffer a big loss sooner or later.
And you will be forced to exit the forex market after incurring irreparable losses.
If that happens, it is a dream come true to make a profit in Forex.
George Soros, the king of investment, said…
“Survive first. Then you can make money.”
In order to survive, you must admit gracefully that your entry was wrong and cut your losses honestly.
Cutting your losses is not a defeat.
It is an act of “regaining your financial freedom” in order to release your hobbled margin and move on to the next trade. Then, with a clear mind, you can take another chance on the next trade.
Please refer to the story of a famous trader who went bankrupt because he took too large a position and averaged down even more.
Origin of the term “averaging down”
The word “averaging down” is written in Chinese characters as “難平”. The word “nan” means “difficulty,” and “taira” means “to make things easy”.
In other words, it means to make peace with a difficult situation – to try to get through it safely.
This word has a long history and was used in the world of the rice market during the Edo period in Japan.
Even in the Edo period, averaging down was used to mean “a fool who postpones losses,” indicating that averaging down had a bad image from that time.
The above is a glossary of FX terminology that tells you the meaning of averaging down in FX and how to enter the market tactically.
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