Ways to Play Defensively

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Author: Larry Potter

Article source: http://coffeecafe1132.blogspot.com/. Used with author's permission.

We don't consider playing defensively a way of buying "safe" stocks because safe stocks won't make you any money. We need movement, but there are ways to help you survive huge mood swings that the momentum stocks can display. Today we are going to look at the idea of "averaging down" and if it is a good idea or not. It is not an easy answer.

The concept behind averaging down is that if you buy XYZ at 100 and it falls to 90 and you buy more, your "average" cost is just 95 now. So if XYZ bounces up, you only need to get to 95 to break even on the trade. The idea sounds reasonable, right? Well, "maybe/sometimes".

For the most part the problem with averaging down is that people use it to justify a poor trade. If you buy into XYZ with the idea it is going up and it starts to fall, you have to ask why? If the market is healthy, and XYZ hasn't released any bad news, XYZ should be at least holding its own right? Well someone doesn't like it and you don't know the reason why, yet. Now, suppose you buy more XYZ to "average down" and then the next day "boom" they release some type of bad news. You have effectively bought more shares of a poor trade. So in this instance averaging down has hurt you. So naturally the question becomes, "should you ever average down?" and that answer is "yes" at times.

Let's use an example: Suppose you are into XYZ because they just announced good earnings a day ago and they are trading higher. But then ABC who is in the same sector announces earnings and they miss by a mile. More times than not the stocks in the whole sector will get hit a bit. Generally this is a sympathy fall and since XYZ didn't do anything wrong, buying more on that type of dip is often a good idea. They aren't usually long lived and you get the chance to buy some more XYZ at a bargain price.

**Part 2

What about buying more (averaging down) simply because the market is having a bad hair day? This gets tricky, but try and follow the reasoning. It all depends on what XYZ has done lately.

For the most part, if XYZ has had an "orderly rise" and they take a step backwards because the market burped, we have no objections to averaging down and buying up some more, in hopes that the market will rebound the next day and XYZ will be on the move again. BUT and this is very important, if XYZ has already run for several points, the answer gets very hard to say. We are conservative about a lot of things and when a stock has moved several points in two weeks and then it gets smacked in a nasty market sell, we do NOT recommend buying more and averaging down. Why? two reasons. First, if you are already up 5 dollars and XYZ gets hit for 2 in a one day drop, you are still up 3 bucks. But if you buy even more and the market falls yet another day, now you have really eaten into your profits. Since we never really know how far a market will "shake out" you could be buying into a pretty big hole. So, what we like to do in an instance like this is simply take your profits from the first fall if it violated your stop loss point. If it wants to fall more, you are out with a good profit and when it bottoms out and starts back up you can buy in again. If it doesn't hit your stop loss point on its first fall, instead of buying more, sit tight and see what the next day brings. If the next day looks like it wants to rebound, THEN, buy some more. 

We stress this point for one reason. Some weeks many stocks fall several points in just days. Sure, you might be expecting a shakeout and get it, but what happens if it doesn't pop back up? This happened to the Internet stocks back in April of 1999 and a lot of people were trapped all summer "hoping" to get their money out. So, the point is, averaging down does have its place if used wisely. But we don't use it to justify a poor trade and we generally don't use it to add to a recent high flier that is falling apart. We would rather sell out that high flier, pocket our winnings, and buy back into it once it has bottomed and started climbing.

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