A) Back in the the “Averaging Down” was called scale trading. There were occasional systems or CTA’s that did OK with it, but most were disasters eventually. The idea then was to “scale in” to something like corn when it reached a historical or seasonal low end range (say $2) and keep buying as it dropped ($1.95, 1.90, 1.85, etc.). The problem was corn might go to $1.80 and stay there for a while before bouncing to $2.20 or whatever. In theory you will eventually turn trades like this into winners, if you don’t go broke first. The bottom line is this is no different from doubling your bet every time at the black jack table. Eventually you will win back your losses, if you don’t run out of money first. In Corn there is a probability that Corn will rally back above 2.00. In the casino there is a 48/52 chance the next hand will win and a 100% chance that eventually you will win a hand…the question in either case:
will you go broke first?
B) I agree with Pal <VBG> in that you could have a system that averages down some in the context the system. Let’s say a system has a buy at 100 and a stop at 90. After the buy at 100 the system has another buy at 95 and leaves the stop at 90. IMHO, that’s OK.
However, look at the 2.27.07 trades of those vendors that are arguing for
averaging down. The markets were in free-fall after breaking down out of an extended low volatility contractions. Momentum was down. Hourly, daily, and weekly channels were broken or not yet reached. If averaging down in the middle of such an event is part of their plan the subscriber must ask himself “do I want this to be part of my plan”? The potential for disaster is high and I suspect vendors that are averaging down into such events really don’t have a plan for those events and these trades are not in the context of a system.
C) I agree that technical indicators like MACD, Stochastics, etc. are in and of themselves nearly useless, I disagree that all technical measures are without merit. Moreover, there is empirical evidence
that certain measures have value. There are systems that use
volatility, trend, etc. that have multi year and even multi decade
winning performances on record. There are technical indicators
right out of the box that measure these things, and while as Ross suggests you can’t just buy when indicator X get to value Z, (many “tests” of technical indicators that “prove” they don’t work, work this way) you can use these indicators to produce valuable methods in conjunction with price.
A) In theory you will eventually turn trades like this into winners, if you don’t go broke first.
The company of which you bought shares shouldn’t go broke either. So even if you don’t go broke yourself there is a risk.
One way to avoid that you run out of money is to average down more modestly. If you want a position of maximal $x then add $x*2**(-n) on step n (i.e. instead of doubling each step, add only half of the previous step). In this way you can average down infinitely while your total position will never exceed $x. Actually this makes sense only 5 or 6 steps, after that you will add no more than 1% of x.
The point of this is that, in theory, you can average down repeatedly and still respect a the maximum position size that was set in advance. Of course the probability that the trade eventually becomes profitable will be smaller in this way.
A) Back in the the "Averaging Down" was called scale trading.
Oops! That would be " Back in the day "Averaging Down" was called scale trading."
Hi Jules,
Unlike options were your risk is limited to the premium you paid, you are faced with multiple risks when averaging down with stocks even if you use sophisticated techniques such as the one you described; your first risk is that the company takes big risks in the marketplace, losses money, stops trading, and its stock goes to near zero just like what happened last week with NEW. It was trading around $51 nearly a year ago and now
its not trading at all. Your second risk is the “loss of opportunity” if the company you’re averaging down with, goes down either slowly or fast and then ends up staying down for a long period of time preventing your money from growing when other stocks of companies are appreciating around you. A good example is what happened after the 2000 bubble burst period. Many people fell into the mindset that their stocks would rally back with a vengeance and accepted the fact that it’s ok for them to “take a breather” for a few months. Well, It turned out to be one very long breather 
However, when you average down with options, and your methodology tells you where your average levels are and when to stop averaging altogether, yet the stock continues to go downward or upward, the most you would lose is a fraction of the price of the stock ranging from 5%- to 25% depending on the risks you’re willing to take. So a $60 stock with a 60 strike that costs 3.00 cannot lose 3.50 if the stock takes a drive to Aunt Rose who lives in the $50 level and decides to move in with her for a long period of time 
Naturally, there are other risks associated with options that don’t exist in stocks, but that’s for another topic.
Regards,
Tarek
>Unlike options were your risk is limited to the premium you paid
Options, in general are more riskier than the underlying instrument it is based on, because of the time decay…
>You are faced with multiple risks when averaging down with stocks even if you use sophisticated techniques such as the one you described
It is my opinion that it is not a sophisticated technique but a wrong technique. A better technique would be to average down on the underlying instrument and at the same time balance it with put options if one is long and call options if one is short, thereby converting a long straight position into a long call or a short straight position into a long put…
>your first risk is that the company takes big risks in the marketplace, losses money, stops trading, and its stock goes to near zero just like what happened last week with NEW.
With my above described technique, all one would’ve lost is what one would’ve lost holding a long call. The combined long straight position and long puts would behave exactly like a long call…
>However, when you average down with options…
Your technique is more riskier than combining the averaged down straight underlying stock position with options…
Nice try…
> Your second risk is the "loss of opportunity"…
This is a very good point. Indeed there are daytrading systems that are
only in the market 5-10% of the time. This leaves you free to pursue
other opportunities as well.
>Your second risk is the “loss of opportunity” if the company you’re averaging down with, goes down either slowly or fast and then ends up staying down for a long period of time preventing your money from growing when other stocks of companies are appreciating around you.
It doesn’t have to be a “loss of opportunity.” Using my technique, one can load up with puts (LEAPS), and wait for a turnaround. When the turnaround comes, one can sell the puts and remain long the straight underlying stock and thereby ride a bull market to the top. Just the reverse for a short underlying stock position.
>Many people fell into the mindset that their stocks would rally back with a vengeance and accepted the fact that it’s ok for them to “take a breather” for a few months. Well, It turned out to be one very long breather
Good point. That is why it pays to diversify into alternative investments like futures and forex inaddition to stocks.
>It doesn’t have to be a “loss of opportunity.” Using my technique, one can load up with puts (LEAPS), and wait for a turnaround. When the turnaround comes…
That should read IF the turnaround comes (see actual equity curves for proof)…and keep in mind LEAPS aren’t free either. It ties up equity either way.
But the puts would gain in value to offset both the loss in equity caused by the sliding long position in stock and the cost of the put. If the turnaround does not come, all one would lose is what one would’ve lost holding a long call…
"It doesn’t have to be a “loss of opportunity.” Using my technique, one can load up with puts (LEAPS), and wait for a turnaround. When the turnaround comes, one can sell the puts and remain long the straight underlying stock and thereby ride a bull market to the top. Just the reverse for a short underlying stock position."
That’s the wrong way of using options simply because of gamma. Thus you have no real sustained edge in the long term except with sustained one -directional moves. We also know that markets spend nearly 62% of its time trendless. Unless you’re an excellent stock picker knowing full well that the stock will trend which no one can predict with decent accuracy, your results will be mixed at best. However, maybe I’m missing something.and since you have 11 systems, why don’t you start a 12th one and prove it to all of us naive traders. I might even subscribe if after 2 years you can prove your theory is correct… What say you.
>Unless you’re an excellent stock picker knowing full well that the stock will trend which no one can predict with decent accuracy, your results will be mixed at best.
Of course, stock selection is equally important as timing mechanism and money management, just as a 3-legged stool needs all of its 3 legs to feel comfortable to sit on it.
>However, maybe I’m missing something.
I think you are. Optimal dynamic asset-allocation (short-term trading stocks/options etc.,) policy is generally unattainable due to transaction costs (commissions) and other market frictions (slippage), but can be approximated with just a few options in a buy and hold portfolio given that only a few trades are required to establish the portfolio and there are few costs to bear thereafter.
An even more compelling motivation for the optimal buy-and-hold portfolio is the presence of taxes. For taxable investors, the Certainty Equivalent is reduced by the present value of the sequence of capital gains taxes that are generated by an optimal dynamic asset-allocation strategy. In contrast, all of the capital gains taxes are dererred until a future point in time in a buy-and-hold portfolio. Therefore, the economic value of predictability is likely to be even lower for taxable investors, and the optimal buy-and-hold portfolio that much more attractive. The main
challenge however is tractability and computational complexity.
Studies have shown that as the number of options increases, the investor’s welfare increases, so that for say, 5 options (n = 5), the Certainty Equivalent (CE) of the optimal buy-and-hold strategy is around 34.9% of the CE for the optimal dynamic stock/bond policy.
Although this is a considerable improvement over the case where thare are no options (n = 0), it is still quite far below the optimal dynamic strategy’s CE.
As the number of options increases beyond 5, this approximation will improve eventually, but the optimization process becomes considerably more challenging for larger n.
For example, the n = 15 cases involves (45 strikes X 15 options) factorial = 344 867 425 584 sub problems, and even if each subproblem requires 0.01 seconds to solve, the overall optimization problem would take approximately 109.4 years to complete.
When options are allowed in the buy-and-hold portfolios, additional risk-reduction possibilities become feasible and the optimization algorithm takes advantage of such opportunities.
Call options are generally more risky than the underlying stock on which they are based. See for example, Cox and Rubinstein (1985) Options Markets (Englewood Cliffs, NJ: Prentice Hall). The stock returns are more predictable, hence there is greater value to be gained from investing in stocks for each level of risk aversion compared to options. Alternatively, the predictability in stock returns make stocks less risky, ceteris paribus, hence even a risk-averse investor will hold a larger fraction of his wealth in stocks in this case.
Deriving optimal buy-and-hold strategies to approximate other than dollar-cost/zero-cost averaging strategies or other popular dynamic investment strategies - strategies that need not be based on expected utility maximization might be of considerabely lesser interest.
We have to examine the payoff structure of the portfolio and its sensitivities to various market factors and economic shocks.
>since you have 11 systems, why don’t you start a 12th one and prove it to all of us naive traders.
My existing stock method would do the job. I don’t have to prove to anybody about anything, naive or sophisticated traders. You are free as any other to adopt or discard my suggestion, anytime…
>I might even subscribe if after 2 years you can prove your theory is correct… What say you.
I think I would welcome a pro like you subscribing to my methods (which are open to subscribers), anytime, but that remains to be seen…
My example was only meant to show that repeated adding to a position does not necessarily entail a position size that exceeds the bounds set in advance. It is not a particularly smart example since everyone with a week calculus can write down a monotone convergent series.
So a $60 stock with a 60 strike that costs 3.00 cannot lose 3.50 if the stock takes a drive to Aunt Rose who lives in the $50 level and decides to move in with her for a long period of time Naturally, there are other risks associated with options that don’t exist in stocks, but that’s for another topic.
Unless the person who considered to buy one lot of $60 stocks does not replace it by one $3 option while he leaves the rest of his $6K untouched, but buys 20 of such options. In that case he can still loose the full $6K and in fact that is much more likely than if he buys the stocks.
Nevertheless I agree that the risk of averaging down depends on the kind of instrument.
I also agree with what others said, that it cannot be a substitute for bad picks. A system that picks no better than randomly cannot turn that into profits by averaging down according to any scheme - at least not in the long run.
Depending on the kind of system and the distribution of returns I think that some forms of averaging down can improve profits, like in the example that Sam gave (buy at 100, add at 95, sell at 90).
It is also true that there have been many examples here where averaging down turned out to be a disaster very soon. Most of the times this was due to the position size. So I think that the original post that started this discussion (Beware of systems that average down) is largely correct. But there are exceptions, notably mechanical systems where averaging down is limited by strict rules (like in Tango), and where it is not done as some twisted form of money management to compensate for bad stock picks.
"Unless the person who considered to buy one lot of $60 stocks does not replace it by one $3 option while he leaves the rest of his $6K untouched, but buys 20 of such options. In that case he can still loose the full $6K and in fact that is much more likely than if he buys the stocks."
Yes that’s correct and that person deserves such a loss.
"Nevertheless I agree that the risk of averaging down depends on the kind of instrument."
I think intimately knowing the personality of that instrument more than the kind of instrument itself eventually dictates your level of success.
"It is also true that there have been many examples here where averaging down turned out to be a disaster very soon. Most of the times this was due to the position size…"
Not necessarily true Jules. Don’t get me wrong; while position sizing has a big effect on your bottom line, it’s the timing of your averaging operation and the ability for that instrument to turn around is the key to sustained success. Trading in an unhedged dynamic fashion is a recipe for disaster as many futures systems witnessed recently. You can be right 80-99% of the time but when a 4-6 sigma event takes all your hard work away, you become humbled very quickly. We can argue that stops must be placed accordingly.They are fine in normal market conditions, but have their drawbacks in a severe market downturn like what happened on 2-27. More than likely, traders would have gotten sell fills near the bottom.
Averaging down is an art and science that takes years to master. However, that is only one dimension of the trading game. Four other dimensions must be exposed and resolved to succeed in the options game - Volatility, timing, sizing, and proper pricing of options in addition to the correct process of averaging down. Pinnacle went from a low of 24k to 900k partially because of it. But Volatility was the ultimate factor at the end and currently, it is bringing it down to its knees 
I have been there before though.
> you have no real sustained edge in the long term except with sustained one -directional moves. We also know that markets spend nearly 62% of its time trendless.
Right. So there will be a range of price where the option AND the stock trade will both lose. Even if the stock trade “wins” the net result
could be a loss.
> However, maybe I’m missing something.and since you have 11 systems…
Interesting that Pal claims several of these 11 systems are in test mode,
but none of them are used to “test” this method which he has written 10,000’s of words about.
"Right. So there will be a range of price where the option AND the stock trade will both lose. Even if the stock trade “wins” the net result could be a loss."
Yes, that’s partially correct Sam. What happens with what Pal described using LEAPS, is that both stock and the option have very low gamma. High gamma is essential as it manufactures deltas which you need to ultimately make money. So since a stock has 0 gamma and LEAPS have very small gammas, any gains in the stock is offset by the loss on the LEAPS because LEAPS are heavy in premium thus their deltas change very slowly. Only when the stock exits the range that the LEAPS have priced in will the position become profitable and more so if the trader gets lucky and his stock starts to trend very strongly. In the options game, there’s no free lunch. You have to work for it.
> What happens with what Pal described using LEAPS, is that both stock and the option have very low gamma. High gamma is essential as it manufactures deltas which you need to ultimately make money. So since a stock has 0 gamma and LEAPS have very small gammas, any gains in the stock is offset by the loss on the LEAPS because LEAPS are heavy in premium thus their deltas change very slowly. Only when the stock exits the range that the LEAPS have priced in will the position become profitable and more so if the trader gets lucky and his stock starts to trend very strongly. In the options game, there’s no free lunch…
I understand but it makes my head hurt…that’s why all I ever do with
options is write 'em. And I do that on a very short term directional
trade, with near the money, near expiration options. So if the index pops a few points I’m out with a profit, if it goes nowhere for a few hours I’m out with a smaller profit, and if it goes against me I’m out out (quick) with a small loss. I prefer to run up with the up escalator, rather than fighting premium deterioration (like running down the up escalator).
And if a stock trade doesn’t work I just get out. Why mess with the options if things aren’t going right? You just end up with more ways to lose, and fewer ways to win.
Sam,
One of the keys to trading options successfully is to structure high gamma positions that will gain rapidly with slight movement of the stock. Your enemy is time of course. Naturally, I could have resorted to selling options to hedge time decay when I started Pinnacle some 3 years ago but I am first and foremost a volatility trader and discovered early on that it’s better to engage in large and volatile moves in stocks than to sell little premium and cap my earnings. If the trader is good with timing the velocity, duration, AND direction of the move, the returns far outweigh selling miniscule premium. You can see from Pinnacle’s record that it participated in many 4 - 6 sigma moves on stocks were if I resorted to premium selling, Pinnacle wouldn’t have reached the high mark. Yes, we can argue with the realism factor and so on, but that algorithm with due respect to Matthew has yet to be fixed for option trading systems.
"I understand but it makes my head hurt…that’s why all I ever do with
options is write 'em. And I do that on a very short term directional
trade, with near the money, near expiration options. So if the index pops a few points I’m out with a profit, if it goes nowhere for a few hours I’m out with a smaller profit, and if it goes against me I’m out out (quick) with a small loss. I prefer to run up with the up escalator, rather than fighting premium deterioration (like running down the up escalator).
And if a stock trade doesn’t work I just get out. Why mess with the options if things aren’t going right? You just end up with more ways to lose, and fewer ways to win. "
That’s fine if that’s your startegy and little profits makes one happy. But with the relatively large spreads options have (unless your trading QQQQ’s), I prefer to scalp futures for that kind of profits.
> That’s fine if that’s your startegy and little profits makes one happy. But with the relatively large spreads options have (unless your trading QQQQ’s), I prefer to scalp futures for that kind of profits.
I prefer futures too, but I have traded options this way.
In trading, the magnitude of wins is more important than the frequency of wins. This applies especially to options. A few wins more than offsets the large number of relatively small losses. Those wins are more likely to occur in the case of rare events which necessitates the use of put options in the first place which is what really matters.
http://www.therootofallgoodismoney.com/Babe-Ruth.html
The use of options as an hedge is a standard strategy. There is absolutely nothing new here. So, I’m very surprised that anyone would even ask for a proof that this strategy works…
