There are two schools of thought when it comes to buying more of a losing position…
One school says, “Never, ever do it. You’re wrong on the trade. Don’t compound the error by adding to the position.”
The other school says, “If you liked the stock at higher prices, and everything else is still the same, then you have to love it at lower prices. You should take advantage and buy more.”
Personally, in my 36-year career trading stocks and options, I’ve attended both schools. Here’s what I’ve figured out…
When you’re buying speculative options, you should never, ever buy more of a losing position (unless you started with just a partial position and intended to buy more to complete a full trade). Options are wasting assets. They lose value with the passing of each day.
It is usually a bad idea to buy more of a wasting asset that’s going in the wrong direction. I’ve done this plenty of times during my trading career. And I’ve regretted that decision probably more than 90% of the time.
When I’m trading stocks, though, I’ve had quite a bit of success averaging down on a losing position – especially when I can’t find a logical reason for the trade going against me.
I won’t average down if there’s something fundamentally different about the business that I missed in my original analysis. But, if everything is still the same and I was just early in buying the stock, then it makes sense to take advantage of the decline and buy the stock at a lower level.
The risk, of course, is the declining stock price may be discounting an event that I haven’t considered. But, if that event was truly detrimental to the underlying business, then the bond market would also be discounting the event and the company’s bonds would be trading lower.
Here’s the point I’m getting to…
If a stock price is declining and there’s no news to justify the drop, then pay attention to what’s happening in the bond market. If the bonds are selling off too, then there’s something else going on that you hadn’t considered.
You’re better off getting out of the trade and taking a loss on the position – because that loss is likely to get bigger.
Now, I’ve told stories about this strategy before. And I stick by what I said… “averaging down” is usually a bad idea.
But on the other hand, if the stock is selling off for reasons you can’t define, and the company’s bonds are holding their value, then the selloff in the stock is emotional – not logical.
Take Newell Brands (NWL), a stock we recently traded in the Delta Report for a 175% gain…
We originally entered an uncovered put position in NWL back in July, when it was trading around $26 per share. But, the stock got smacked on a bad earnings report the following month.
I watched NWL tumble all the way down to near $16 per share. My subscribers sent me angry emails. You could hear an odd knocking noise coming from my home office… My forehead banging against my desk.
But the stock had no business trading at that level. At around $16 per share, NWL was trading at seven times next year’s earnings estimates. It paid a remarkable 5.3% dividend. Corporate insiders were buying the stock above $20 per share.
And here’s the clincher… the long-term bonds of NWL were trading near par value.
If the company was in financial jeopardy, then the bonds would be priced at a discount. But, that wasn’t the case.
So, at the risk of pitchforks and torches, I instructed my subscribers to buy NWL calls in anticipation of a rally. And sure enough… From its low of $15.40 in late October, NWL shot all the way back to around $24 earlier this month.
Here’s my point…
The market is often irrational. The most profitable move is not always the most obvious.
And when a stock tanks on a short bout of bad news, while the rest of its business is standing strong… it can be quite profitable to average down on a losing position.
Best regards and good trading,
P.S. The markets have been that same kind of irrational lately… and strategies like what I just showed you are what will keep your portfolio safe.
Keep an eye on your inbox for this Friday’s Market Minute. There I’ll share another strategy that will be key to a successful trading year.
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