I once attended a rather Pentecostal Church about 10 years ago. Not the “handling snakes” and “rolling around” kind, but more along the lines of the “word of faith”, “speaking in tongues” kind.
I remember it like it was yesterday. I was a part of the worship team and had just gotten off stage when the service had ended. A lady came up to me and chatted me up as she did every Sunday and told me she had a gift for my birthday. Quite taken back and reluctant to receive a gift in Church I responded, “Oh thank you…” and before finishing my sentence, she started quoting a Bible verse from Ephesians and looked at me and smiled and said there is your gift. I stood there shocked not understanding exactly what had happened, I was expecting a 2-year-old Werther’s original, or even a card. But a Bible verse that came out of nowhere with no life application around it, that she very confidently rattled off like she had it in her holster ready to whip out at any given moment? Was this something she thought about for the past few days and found to be certain to change my life? Or was this her George Costanza’s “The Human Fund”, to fall back on when ill-prepared to celebrate special events without putting in any work?
When presented with dips and corrections in the Markets, our long positions obviously suffer. But sometimes the safest plays are to make no plays at all. Market dips increase volatility, which is a trader’s best friend, and with volatility upticks and expansions brings swift fast bursts and movements in underlying’s, sometimes favoring your directional assumptions sometimes not.
There are many ways to play a correction, the most common being “averaging down”. If I purchase a stock at $10 and the stock falls to $8, I can purchase more shares at $8 and my average cost in that position will be around $9. But what happens if the stock does not rally again and continues dropping? Well now I am just losing money twice as fast as I was, and we repeat the process.
Averaging down is also something to be especially leery of when derivatives such as “options” are the table. Not only do you have direction and volatility against your position, but you also have time value wrapped into the contract as well. So, we need to be keenly aware of the overall Markets, our directional assumption, and account allocation and leveraging before making any drastic moves to certain positions.
A good practice I like to implement is called the “Shirley Test.” Little did that crazy lady know at Church that Sunday after the service, that she would now become a staple in my daily trading. Before we start to average-down we must ask ourselves, are we overreaching? Meaning, just as Shirley did on that Sunday when giving me a wonderful present of a verse I can’t remember, are we forcing something to work in a position, trying to “speak life” into something when the markets and underlying are telling us otherwise? Or are we ill-prepared for such moves and just overreacting the best we know how, trying to save ourselves the embarrassment of a position that did not work out? Just as Shirley, quickly thinking on her feet, gave me something that she thought would suffice.
In Conclusion, do not be a Shirley, examine your account size, your overall portfolio Delta and forward-looking assumptions, and Market news and events, before “Averaging Down”.