The Fallacy of Doubling Up a Losing Position:

Sending Good Money After Bad

If you read the stock market Internet message boards (and who doesn’t at one time or another?), you’ve probably read posts by traders who double up on a losing position. As soon as the stock starts slipping, they’ll broadcast to the trading world that the reversal is actually a miracle in disguise and a rare buying opportunity. “Back up the truck,” they tout, “this is a blessing made in heaven."

In stock trading parlance, this is called “averaging down.” It refers to buying more shares of a stock as the price declines, thus locking in a lower average price on your total position (as compared to the initial purchase price).

For example, let’s say you buy 1000 shares of Royal Gold (RGLD) at $45, but the stock backtracks to $35 Aside from the fact that prudence should have told you to dump the stock before it fell 12% (see our Top Three Trading Rules), as in this example, the folks who average down buy another 1000 shares at $35 and thereby reduce their average total cost.

The champions of this tactic believe, of course, that the stock is showing a temporary market dalliance, and it will come charging back and either make break-even twice as easy to achieve, or better yet, generate some real cash when the stock returns to their original point of entry and keeps on rising.

Well, that’s the cheery little “averaging down” scenario, but the experts say doubling down is a recipe for going broke. It runs counter to the day trader’s mantra:  buy more of winning stocks; dump stocks that are losing.

Still, there’s hardly a trader around who hasn’t broken this rule, me included. And if you do, don’t throw discipline out the window. Instead, set new mental (or actual) sell stops to extricate yourself from this trade in case your hunch leaves something to be desired.

If you originally entered the trade intending to lose no more than say, 35-cents a share, but now you’re down 70-cents, set a new stop for the second buy another 35-cents lower than your point of entry. If it crashes to that point, cash out and call yourself fortunate.

It’s been said time and time again: the way to make money in the stock market is to keep a tight rein on losing money. The winning trades will take care of themselves and you’ll be all the richer for it.