FX Averaging – Forex Academy

I have seen in several forums that many investors practice the risky sport of averaging down. This strategy is nothing more than investing more money every time the stock/ ETF/ Fund, etc goes down, so we get a reduction in the initial cost by buying more shares at lower prices.

This strategy has several problems…

– Each time we average to lower the average cost we add more money, therefore we add more risk.

– “Money Management” or money management strategy is a martingale (I buy when I lose, that is when I lose). This strategy is perfect when our capital to invest is infinite, which is not very likely.

– It is not recommended unless you know how to do it, because if you do not do the strategy well or do not choose the underlying well, the losses can be very painful.

– We are invested in a broad ETF (there are many companies and good ones) and the ETF has downward swings because of the feeling of the market, and not because of the quality of the companies that compose it, so it is an inefficiency that we could take advantage of if we have liquidity.

– Exactly the same as the previous point but with an individual company. Here I have to say that you do not do it, do not lower your average in individual companies, unless you know how to read a balance sheet and trust very much in your judgment that the company is good and will continue to make profits.

If you still want to average down we’ll see how we can do it. The example I am going to give with a company, and this example can be extrapolated to an index. The company XZY is a large company, what’s more, I would say it is a very large company, with annual dividend increases of around 7% on average, improved margins has an impeccable balance sheet, etc, etc, etc. Ultimately a really good company with very little chance of going into losses, although this is never 100% reliable.

Once we know that the company is very good and its balance sheet is difficult to get worse enough we want to enter it to take advantage of its current price and be able to get quite good returns. The intrinsic value of the stock is €100, and it is currently listed at €60, so it is trading at a 40% discount. I think it’s enough of a discount to go in and have a good long-term return.

I have 10,000€ to invest in the value, and at 60€ I will buy 100 shares of the company, so I will invest 6,000€ initially. Now, because of the current market situation, because of the phase of the cycle in which we are, because the political situation of the country is this or that, etc… it is likely that the market will punish the quotation and we will see it below, even though it is an incredibly good company, which gives us the possibility to buy more shares (more risk) in exchange for lowering the average cost (more profitability) and when quoted at prices close to its intrinsic value, get a few more points of profitability.

Then let’s try to figure out what a super price would be. The super-price is the price at which the company is a very clear investment opportunity and will give us really good long-term returns. For our example I estimate that a super-price for the company is 40€ per share, that is, we shouldn’t care if it goes any lower, because at the price I buy the company, earns enough so that the money invested in it has all the possible guarantees of getting the full return on my investment plus high returns.

At this point, I have 4,000€ in liquidity and a difference of 20€ between the current price of the stock and my super-price. Now the price difference between the current quotation (60€) and the super-price (40€) we have to divide in equal parts, and in the same way our capital in liquidity. Therefore we can divide our capital into 4 parts of 1000€ each and the 20€ difference into 4 parts of 5€ each and in this way we already have the levels in which we will invest additional 1000€ each time the quotation drops 5€ and we will have enough liquidity until he goes down to our super-price.

A rule for you to do well is not to average a price that is less than 8% difference between the initial purchase and the next purchase to average, that is, I will not buy the company at 60€ and at 59€ I will re-invest. Such a small difference between the different prices will not excel in the returns of this long term. In the example I have explained the difference is greater than 8%, so it compensates for the risk with the possible long-term reward.

If instead of having bought 6.000€ initially we had bought less, 3.000€ for example, we would have 7000€ in liquidity to average, we would again divide the difference between the current price and the super-price and divide it into 3, 4, 5 equal parts (to the taste of the investor) and buy when it comes at the price we agreed. This is the standard way of averaging.

We can also increase or decrease the risk by doing the average in different ways…

– Increase the risk: Instead of dividing our capital into 4 equal parts I will give more money to the latest purchases, for example: Instead of buying 1,000€ each time I lower 5€ the quotation, the first 5€ I lower (the quotation would be 55€) I will buy 500€ only (I have left in liquidity 3,500€, the second purchase at 50€ I buy for 800€, the third for 1200€, and the fourth and last for 1500€.

– Reduce the risk: Exactly like the previous point but in this case, the first purchase to average is the most money we invest, and the last one the least, we would invest 1500€ first when the quote reaches 55€, 1200€ when it reaches 50€, 800€ when it reaches 45€, and finally 500€ when it reaches 40€.

By reducing the risk, I am not referring to the operation in general, but to the strategy of averaging downwards. Another day we will talk about selling a part of the portfolio to reduce the risk of the transaction in general.

-It is different from the average if we invest 6.000€ in the first purchase than 4.000€, the more money you invest in a certain price, the more the average cost will approach this.

– We can use the 3 ways of averaging, we just have to know what our profile is and if we will find ourselves doing this high-risk strategy.

– Never weigh at prices below 8% distance between several purchases. The risk does not compensate for the reward.

– It is not the same as a super-price for our example of 40€ that 59€, here it is clear that I will not average, it is not higher than the minimum 8%.

– In companies it is very risky, I would not advise you, you must be almost professional to do it in companies. In indices, it is different, although not all indices, choose one with large companies, and enough, SP500, Eurostoxx300, the VT would be perfect, etc. An idea to know a super-price of an index is to see the return for a dividend that gives and with which you would agree.

This is all, a risky strategy, but using it with a lot of heads and a lot of care can give us joy. As a last remark I repeat that I do not advise this technique in companies and in indices if you do not know how to use it well, it is very dangerous, but now you’re a little more knowledgeable about how to do it and avoid serious mistakes by buying too soon or in an underlying evil.

0101Price action and swing trading methodologies per se provide a powerful way to operate in markets, but when they are complemented with average value analysis, you can start to “see” much more. The word “average” is synonymous with the word “average”, which is widely used in financial markets, including the stock market. However, this can be an important tool when used correctly. Mathematicians, Scientists, and Data Analysts usually use the power of the average in clinical trials, predictive analysis, and other applications to predict things. In this article what we want most is to show them how the power of simple average can be applied to your forex trading.

The Wisdom of Crowds: Average on Forex

The power of averaging comes to light when used with “crowd data”. Keep in mind, when analyzing a price chart, you’re looking at the average combined thinking of all traders in the market, who are being represented in the price. For example, do you know those quizzes about guessing the amount of candy in a jar? Most people will be far away from the actual number with their assumptions, some as much as 100 times above or below the actual amount. In fact, out of 160 people, only about 4 would approach the real value.

The interesting thing is that, even though no one usually gives the correct answer, “everyone” (as a group) comes up to a fairly close number. The typical scenario shows that when the amounts said by the public were averaged, the resulting number was something like 5,231.77 when the actual amount of candy inside the bottle was 5,240. This means that data collected from the entire public were able to accurately determine how many candies were in the bottle with a difference of 9 candies, which would be a margin of error of approximately 0.17%.

This example is quite amazing and shows the power of averaging. A Youtube channel did this experiment on the candy jar, letting people put their amounts in the comments. When the results were collected and averaged, the average was within 4% of the real value. Usually what happens is that people who overestimate are canceled by people who underestimate, which naturally filters out the bad estimates. What this shows is that you can collect everyone’s thoughts and average them to get something that is mysteriously close to real value.

Probabilities and averages should be the backbone of your risk management. Another unexpected place where averages play an important role is in our risk management plan. This will certainly have a consequence on the way you think and respond to your trading performance on a long-term basis. Many forex traders have difficulty making the switch and starting to think in terms of probabilities. Unfortunately, many people have their heads full of misinformation, contradictions, and paradoxes. For this reason, most new traders rank money management and capital preservation much lower than do experienced traders.

But the bottom line is that trading is a math game. You must understand the odds and statistics, and aim to stay on the right side of the numbers by exploiting your advantages in order to succeed. The advantage we teach in these items is to exploit recurring price patterns that continue to be repeated in the same way over time. Always keep in mind, there are a certain number of traders in the market at any given time, and they are doing the same thing over and over again to try to make money. This includes large amounts of “smart money,” such as investment funds and commercial companies that have the largest volume on the market.

This behavior repeatedly generates price action signals that we recognize and use to predict price movements. These signals of purchase or sale on average will behave in the same way as they have in the past, producing results that we can capitalize on. To make the most of the power of averaging, it is also advisable to apply positive risk-benefit ratios to the risk management of our operations, so that the “average” operation will have a profit. When you apply a 1:3 benefit risk ratio to your operations, you can lose 75% of them on average to keep your account in balance (neither win nor lose). In other words, you must win 1 out of 4 operations to maintain balance, or 1 out of 3 operations to earn money.

When you look at your recent operations, you may not see these numbers, but if you continue to apply this principle, the numbers eventually “stabilize” and represent what we are exposing. For example, you could have 4 consecutive operations that end up reaching the 1:3 target, which would be a total return of 12 R (12 times the risk). After this, you could suffer a drawdown period of 5 losing operations, but it wouldn’t really be a drawdown, because you’d still be up at 7 R. On the other hand, this could happen the other way around, losing operations might come first, giving you a -5 R as a result of a losing streak. But if the next 4 operations win, the situation changes completely and you end up with +7 R.

This is somehow to be expected because the market moves through good and bad conditions to make money for each system, and the losing and winning operations will tend to cluster as the market cycles happen. Start using the power of positive risk-benefit ratios and eventually you’ll see the results. All this is true if we assume that you have an advantage in your trading system, such as using price action.

How Most Common Indicators Work

We could stay here and tell you how useless we think the indicators are, but you’re human and your curiosity will force you to explore them for yourself for sure. This is completely understandable, sometimes you need to explore them to remove any remaining doubts in your head about what you might be losing. This way you can know exactly what the indicators are and decide from your own experience whether they are for you or not. When you insert indicators to your charts, they usually expose your data in the form of a line chart or histogram. The indicator is like a “black box” that does the hard work internally.

Would it surprise you if we told you that most common indicators are just a combination of price action data and mathematical averages? Well, it is true. Indicators such as stochastic, ADX, and CCI use the maximum, minimum, and closing prices of candles and pass them through averaging formulas. The ADX recycles its own data through multiple layers of averages.

The ADX is designed to quantify a trend by a certain numerical value. The result is that, if the value is too high, the trend will be more powerful. Here you can see how in the USD/SDG pair we have had this beautiful trend, but the ADX only showed a really confusing graph of lines that does not seem to correlate with the strength of the trend, or stability.

There are some custom indicators going around, which are actually joining multiple indicators within one, in an attempt to develop an extraordinary hybrid indicator. That is why it is well known that indicators have such a horrible natural mismatch. Some are notoriously worse than others, because every time you average data, the end result responds much more slowly to the real movement of prices. When you look at what is happening within most indicators, they are actually just a game with price action data, which are passed through some mathematical averaging calculations, it is not a big deal, just the same type of data but shown in different ways. This could be an advantage for some, but several of us would be frustrated with the performance of the indicators.

It is true that some indicators can work well under specific conditions for short periods, mostly in highly biased markets; but on the other hand, these indicators will give the trader a lot of poor quality buying and selling signals during conditions that are out of the optimal market behavior for which they were designed, and this could be as much as 80% of the time.

Presenting the Average Value Analysis

This is the basis for the analysis of the average value, the study of the price relative to its average value. We use average value analysis to help us determine many things in a price chart, such as:

The direction of the trend
Strength and momentum of the trend
Stability of the market
Signs of climax/exhaustion
Ideal points of purchase and sale
On Price Extension/Opportunities Reversion Operations to Average

The middle-value properties help the trader quickly remove noise, presenting a “summary” that you can use to quickly measure conditions at first sight, and help you make smart trading decisions. But of course, the analysis of the average value is not the only aspect that makes a good sign of trading. This along with price action and swing trading work synergistically with each other to create a powerful trading methodology that helps you read the graphics.