All traders have losing trades, because no trading system is correct 100% of the time. As long as the losing trades are smaller than the winning trades (i.e. a positive risk to reward ratio), or there are less losing trades than winning trades (i.e. a positive win to loss ratio), the losing trades are just a normal part of day trading.
However, it is human nature (or perhaps society's pressure) to want to avoid having any losing trades (no matter how small or infrequent), so some traders use a strategy known as averaging down whenever they find themselves in a losing trade.
Averaging Down Definition
Averaging down is a strategy that is used to lower the average entry price of a trade, and is mistakenly used when a trader is experiencing, but cannot accept, a losing trade.
Averaging down is accomlished by adding contracts (or shares, or forex lots) at lower prices, which thereby lowers the average entry price. For example, if the original entry price was 2500, and a contract is added at 2400, the new entry price would be 2450, as this is the average price of the two contracts.
In theory, averaging down can continue indefinitely by adding more and more contracts at lower and lower prices. In reality, the margin that would be required to continue adding contracts would eventually exceed the balance of the trading account, preventing any more contracts from being traded.
Averaging Down is a Mistake
Traders that use averaging down believe that the market will eventually come back in their direction, and that by lowering their entry price, the market will have to move less distance before their trade comes back into profit. This theory will work some of the time (which unfortunately reinforces the trader's confidence in averaging down), but eventually it will not work, and when this happens the loss will be so large, that most traders will not recover.
Averaging down is an odd concept to believe in, because it is admitting that the trade is not working, but deciding to stay in the trade anyway, and actually increase the amount of money that is at risk. Traders make money over the long term, by keeping their losses small, and taking larger profits when they are available. Averaging down is the opposite of this, as it has the potential for very large losses. Instead of averaging down, traders should have specific stop loss criteria (such as a fixed amount, or an exit signal), and stick to their stop loss criteria without exception.
