How to Lose Everything in the Stock Market Using a Bad Strategy

`By showing you this strategy iI hope that you will not lose everything in the stock market. Because this is the practice taken by novice traders.

• It should teach you what not to do
• Encourage you to do the exact opposite

Unfortunately, for the beginner, this strategy seems quite logical but it is fundamentally flawed. Many people have become stuck in their claws and have lost substantial amounts of money because of its apparent logic. Do not be one of them! The strategy is called averaging down. An example may help to illuminate how this works.

Understanding Averaging Down

Let us assume that you have just bought 1000 shares of stock XYZ for Rs 50 a share. Your intention was that this stock should hit Rs 100 in the next 6 months. You place a stop at Rs 25.

About a month after you bought it, the price has declined a little and it is now trading at Rs. 40. You then decide that you will buy more of the same company at Rs. 40 per share. As such, you place an order for your broker to buy 1000 shares at Rs. 40 each.

You now have 2000 shares altogether – 1000 shares bought at Rs. 40 and a further 1000 shares bought at Rs 50. In total, you have paid Rs 90000 for 2000 shares (40*10000 + 50*10000), which makes the average price you paid per share at Rs 45 (90000 / 2000). You now have 2000 shares that are currently at Rs 40 per share. Therefore, the average price you paid for this is Rs 45.

Let us now assume that the decline continues to Rs. 30. You then decide to purchase a further 1000 shares at Rs 30 per share. This means that you now have 3000 shares at a total cost of Rs. 120000. This makes the average price of each share you paid Rs. 40.

The Pitfalls of Averaging Down

The above example can go on indefinitely, however, let us assume that you have had enough buying and eventually sell all your stock at Rs. 25 per share when you are stopped out.

Averaging Down in Practice – The Path to Lose Everything in the Stock Market

The example above shows what averaging down means. It also effectively means that you dilute the price you paid for each share by buying more shares at a lower price. The theory is that you pay a smaller amount per share and thus reduce your risk accordingly.

Comparing Scenarios: Averaging Down vs. Not Averaging Down

Situation 1 – No Averaging Down

In the example above, you bought 1000 shares at Rs. 50. This cost you a total of Rs. 50000. When the price decreased to Rs 25, you would have sold all your shares at Rs 25000. This means that you took a loss of Rs 25000 to your account.

Situation 2 – Averaging Down

In the example above, you eventually bought 3000 shares at a total cost of Rs 120000. You sold all of these shares at Rs 25 releasing Rs 75000. This means that you took a loss of Rs 45000 to your account.

Key Lessons Learned and Say No to Lose Everything in the Stock Market

In the example above, you took almost 80% more losses by averaging down than by not averaging down – and that is a very big hit to take. The trader in the example did not take into account the following:

• You added to a losing position. Remember the old saying – “Follow the trend”. This means that you do not add to a position that is already losing as the share price will probably continue to go in the same direction!
• You took on more and more risk. Remember that by adding to your position, you are increasing your risk and loss in that position if the trade starts to go against you (and it probably will)!

Conclusion

In conclusion, the allure of averaging down in stock trading may seem enticing, but its pitfalls are undeniable. As illustrated, it’s crucial to resist the temptation to add to losing positions and instead prioritize risk management and following market trends. Overall, by understanding the risks involved and learning from the examples provided, traders can safeguard their investments and avoid significant losses. Remember, wise decision-making is key to success in the financial markets.