Are You Averaging Correctly?
Averaging is a popular strategy in forex trading. Many traders are familiar with it and have used it at least once. However, believe it or not, most traders don't have a good understanding of this strategy. While they know how to execute it, most traders don't fully grasp why they use this strategy.
To address this, in this discussion, we will delve deeper into the averaging strategy, including how to use it, its functions, and other important aspects you need to know about this strategy.
What is Averaging?
In the context of trading, "averaging" or "averaging down" is a strategy in which a trader buys more of a financial asset when its price drops after their initial purchase. The term "averaging" is used because this strategy calculates the average purchase price of your financial asset.
When a trader buys more of an asset at a lower price, they reduce the overall average purchase price of the asset. In other words, they "average down" their purchase price. The goal is to achieve a lower average purchase price than their initial price, so they can reach profit or reduce losses more quickly when the price rises.
Let me provide a simple illustration:
1. You decide to trade the EUR/USD currency pair. Initially, you open a long position in EUR/USD when the price is at 1.2000. So, you buy 10 lots (one hundred thousand units) of EUR/USD.
2. However, the price of EUR/USD subsequently drops to 1.1900.
3. You decide to average down or add another long position by purchasing an additional 10 lots of EUR/USD at 1.1900.
The results are as follows:
- Your initial purchase price was 1.2000.
- Your second purchase price was 1.1900.
- Your total position is now 20 lots of EUR/USD.
If you calculate your average purchase price:
[(10 lots x 1.2000) + (10 lots x 1.1900)] / 20 lots = 1.1950.
Now, your average purchase price is 1.1950, which is lower than the initial price of 1.2000. With this lower average, if EUR/USD rises in the future, you can achieve profits more quickly. This also serves to minimize your risk of losses and increases your profit potential.
Risks When Averaging
Although averaging is a strategy used to manage risk, there are specific risks that can affect you when using this strategy. One of them is the potential for increasing losses as the price continues to decline.
There are times when your predictions are wrong, and the price keeps dropping while you have opened several positions with the goal of averaging. In this situation, if you don't know when to exit, you could incur significant losses. It might even push you to hold your positions until your margin is insufficient or results in a margin call.
Furthermore, when you engage in averaging, you have the potential to switch to martingale. This can happen when losses accumulate and you start to feel increasingly desperate, thinking that the only way to "fix" the situation is by taking on more significant risks. Then you open positions with double the lot size, and before you realize it, you have unintentionally switched to martingale.
A Guide to Safe Averaging
Although averaging carries risks, this strategy can be beneficial and relatively safe when done correctly. Here is a guide you can follow when practicing averaging safely:
1. Create a Plan: Before you decide to implement averaging, establish a clear plan. Define parameters such as when you will perform averaging, how many times you will do it, and the size of additional positions you will open. Remember always to adhere to your plan!
2. Set Stop-loss: Establish a stop-loss level as the point at which you should close all your positions when your analysis is incorrect. This is useful to limit your losses within your tolerance limits.
3. Risk Management: Do not exceed your predetermined risk limits for each trade. Make sure that the potential losses align with your risk tolerance. You can start by opening positions with smaller lot sizes and then increase them in subsequent positions, or vice versa. The essential thing is that you understand the risks and can bear them.
4. Monitor Market Trends: Perform averaging in the direction of the existing market trend. Avoid averaging against a strong trend, as this can increase the risk of losses.
5. Avoid Over-averaging: Do not attempt to "rescue" every losing trade with averaging. Consider wisely when averaging is genuinely needed, as not all market conditions are suitable for this strategy.
By following this guide, you can effectively use averaging as a tool to manage risk and maximize profit potential in your trading activities.
Edited 27 Oct 2023, 01:27
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