Note: This article is the second part of a two-part article. Please see part one here.
Yesterday, we laid down a quick timeline on the demise of the International Game Technology (IGT) trade. Now let's break down the risks of averaging down on losers.
First, there is a concentration risk. Every trader is different, but I think it is safe to assume when most traders take a position it will be somewhere between 0.5% all the way up to 4% of their portfolio. Even if we stay on the low end and say the original position was 1% of the portfolio, then excluding short puts (which are long exposure), the position has grown to approximately 10 times where it began.
In other words, if you started this at 1% of your portfolio, IGT would now be approximately 10% of your portfolio plus short puts. Had you started it at 4%, then it would be almost half your portfolio once you factor in short puts. While a handful of traders in the world can get away with that type of concentration, it will destroy the vast majority of traders. Best case is this has grown to a 5% position. I think that is tolerable, so the lesson here is if you find this type of trading suits you, start with a very small position in case you are wrong.
Second, there is an opportunity cost. The market is roaring to new highs and the buys are chasing a stock to new lows. While it may come back to breakeven or even a profit, how much money could have been made in other areas? In fact, the paper loss exceeds the entire first purchase plus a few bucks. In other words, the Dec. 5 buy -- if the only one -- could have seen the stock go to zero and still be down less on paper, then continually averaging down.
Third, there is complexity. This position has become overly complex. At this point, it is what I call an "Octo-trade," one with eight legs. It is tying up not only physical capital, but also emotional capital in terms of management and adjustments. One position should not be able to occupy all your time plus be the overriding factor in a portfolio's performance. Furthermore, imagine if you have two or three positions like this that performed in a similar fashion -- I'm looking in your general direction Staples (SPLS) or pretty much any momentum name out there, like Twitter (TWTR) or FireEye (FEYE).
I'm certainly one for making trades overly complex. It may be my biggest fault. Sometimes it is easier to walk away. I hate taking losers as well, especially if I feel my valuation thesis is still valid. Several key personality components drive a trader to making decisions such as these.
Averaging down is driven by a few factors with risk compensation being one of the least talked about but most important. This is the concept where traders tend to take greater risk when they perceive safety increases. In this case, the more the stock falls, the more value it has. Did you ever catch yourself saying, "Well, it's down 30%. How much further could it fall?" That's risk compensation.
The more common thought on why folks average down or repair a trade is loss aversion. Traders often want to avoid the shame of taking a loss. They believe there is a greater risk in giving up on a trade than the reward offered by finding a new position, even if that position is cash.
Subject validation is something that I talked about with Doug in the terms of chart patterns, but here it is in terms of valuation and reaction to news. The buyers of IGT view the repeated earnings warnings as an opportunity rather than a concern. It is a better value now at a lower price despite the news and trend. A buyer is required to believe that if they are buying. They perceive it to be true, regardless of the news or price action.
In the case of subject validation, it actually leads to a backfire effect. The reaction should be caution when the company warns repeatedly, but instead beliefs that IGT is just becoming a better and better value are strengthened. This is similar and interchangeable with the Ostrich Effect, where on simply ignores a negative situation. Brush off earnings warnings, layoffs, downgrades, technical breakdowns and the like. This can come in all forms, shapes and sizes and is one of the toughest traps not to fall victim to during your trading career.
Finally, as a contributor, one has to avoid falling into the trap of "availability cascade." Twitter and message boards make this possible even for a trader who doesn't write but may post thoughts on trades. In a nutshell, a trader can believe that if he or she repeats something enough, it will come true. Continue to write how something is a great value or a stock is about to break out and you'll begin to believe that your words will become reality.
Admittedly, there is a lot to take in here, but averaging down (adding to an already losing position) is one of the riskiest actions a trader can undertake. I've seen averaging down, especially on falling knives, destroy more traders than any other strategy. While a few pros, usually with a lot of experience, can make it work, I believe you have to be aware of the reasons behind the actions and fully understand how to control those emotions.
