Losing Trades: When to Double Down

What should you do when a position you believe in moves against you 10% in a few days? This question is a simple one, yet it leads to drastic differences of opinion.

Certain investors believe that if you were willing to buy the stock at a higher level, why not buy more now. Others feel that all investments should be closed after an adverse move and that you should never add to a losing trade. Where do I fall in this argument? Somewhere in the middle.

If you believe in the quality and value of your research, averaging down into a losing trade makes perfect sense. However, the dangers are obvious. Some of the legendary investment failures ­-Long Term Capital, Nick Leeson - involved averaging down into losing trades. Closer to home, anyone who blindly averaged down into Fannie Mae (FNM), Lehman Brothers (LEHMQ.PK) or AIG has seen bad trades turn worse. With such large risks in averaging down, how do we decide when to cut losses and when to push our luck?

When a position moves against you, ask yourself three questions to determine your next action:

1. How much faith do I have in the initial analysis? If you believe the thesis is correct and the market has missed some key factors, stick with the trade.
2. Am I being flexible enough? Even if you believe you are right, you must process all new data objectively. If you made a mistake in the initial assessment, it is time to move on.
3. Can I live with a quantified downside? Average down into the trade only if you can survive a worst-case scenario.

An example of how I have implemented this process in my own investing is my purchase of the Ultrashort Lehman 20+ Treasury Proshares (TBT). As outlined in my weekly newsletter EPIC Insights, I believe the rush into Treasury bonds has created the next bubble that will burst. With that thesis in mind, I bought a position in TBT at $43.81. Two weeks later I had an unrealized loss of 18%, dollar cost averaged into the shares and lowered my cost basis to $40.19. With the shares trading at $42, I now have a 5% profit as opposed to a slight loss.

In order to justify the trade, I examined my initial thesis. I determined that I had honestly processed all relevant information and that my thesis was sound. A Barron's cover story this weekend, "Are Treasury Bonds Safe?", echoes my analysis. When you consider this story occurred nearly a month after I highlighted the trade, subscribers were ahead of the market on this trade. Most importantly, I was able to quantify a possible 9% downside versus a 50%+ upside potential. With such an attractive risk/reward scenario, averaging down was prudent. By staying disciplined and objective, I was able to use a market selloff to turn a losing trade into a winning investment.

Comments

[drone:]

Commenting on this article I'll refer to GE and BA, two stocks I held last summer. At the time these companies seemed like good defensive holds for a number of reasons. As the autumn unfolded and these stocks started going down I could have easily convinced myself that their prices were too good to be true. I could have doubled down bought more, but I didn't. I finally sold my positions in these stocks, the dividends didn't make up for the capitol loses.
When a security is going down get rid of it. Set your loss limit and simply get out. Dennis Gartman reminds us time and again - never ever add to a losing position - never, never, never.

Jan 07 03:58 PM

[fatcat:]

If you are using correct stops,you won't have to make that decision....trouble with that is,like last year,whipsaw kicked your butt.

TBT shouldn't have enough whip to take you out,unless your stops are very tight...

Jan 07 04:02 PM

[igggy:]

Hah, I started buying TBT at 62 and still 25% down. I was too early. They key is wait for the market to confirm your thesis. And use stops for god's sake.

Jan 07 04:45 PM

[bricki:]

Do you you feed a dead horse?

Jan 07 04:48 PM

[Ryan Freund:]

Terry, GE and BA are both wonderful companies. I would have doubled down, and doubled down again, and continued to do so.

Jan 07 05:08 PM

[henarl:]

If a company has good fundamentals and the reason it's down is because the whole market is down (like most of 2008) then adding to your position a the lower price might make sense. If you get out of your good stocks at a loss, what are you then going to do with the proceeds that is any better?

Jan 07 05:23 PM

[sr9web:]

losers average losers

if your original buy due diligence was sound, you'll eventually hit your target - so why try to "average down"?

better to make a 2nd bet on a different stock.

Jan 07 06:00 PM

[igggy:]

Hm, Enron and Worldcom were wonderful too.
I don't think it's possible to know for sure. Yes, GE and BA have enormous moats but it might be years before their stocks recover.

On Jan 07 05:08 PM Freund Investing wrote:

> Terry, GE and BA are both wonderful companies. I would have doubled
> down, and doubled down again, and continued to do so.

Jan 07 07:21 PM

[Anthony Alfidi:]

If the stock has consistent earnings, low debt, and a durable competitive advantage, then a 10% drop is a buying opportunity.

Jan 08 12:29 AM

[ewr:]

I bought TBT at an average cost ot 41.40. It is currently (today) slightly above water, at which I am a little (pleasantly) surprised. My thinking was and is, that interest rates cannot go much or any lower. At some point, possibly 1-2 years from now, inflation is going to kick in and the Fed wil have to raise interest rates. Then TBT should go up. I am prepared to wait. If TBT does go below my average cost, I will probably buy some more, as I still believe that it must eventually go up, because as of today, the Fed only has .25 percent room to lower interest rates. Is there any thing wrong with this scenario ?

Jan 08 02:31 AM

[Maxe Paul:]

I believe it is a wise strategy to double down on long term stock purchases rather than short term plays. If you plan on building a position in a stock over say a 5 year period, then doubling down may be your best move.

If on the other hand you initialy bought a stock for one or two weeks, or day trading, then you must sell, as you risk far more money with little time to recoup.

I would also be wary of trippleing down or worse, anything more than a double down is extremely risky.

Jan 08 05:49 AM

[BerkeleyBob:]

I had held GE for the long term, with some buys and sells along the way. I sold all last month because I did not like the exposure to GE Credit and because I felt J. Immelt had had enough time to change the downward course of the common. It is a tough call, because I like the future prospects of some of GE's divisions (wind power, turbines, medical imaging, etc.) I had no qualms in selling BA because I concluded management had repeatedly fudged on delivery dates for the Dreamliner and drastically miscalculated the predictable union reaction to job losses by outsourcing. I doubt I will reconsider BA unless there is reasonable certainty about performance, may reconsider GE if I see a positive catalyst, not likely this calendar year.

Jan 08 02:18 PM