Averaging - What is it and does it work?

In sports trading you might hear mention of the term averaging. This term is another one taken from the financial world. "Averaging down" is the buying of more stock, if a buy goes against you and "averaging up" is the selling of more stock if a short goes against you, in the hope that the market reverses in your favour.

In sports trading a trader will open a position to back or lay. Let's say that they decide to lay a horse at 3.5 in the hope that the price will increase so that the trade may be closed to realise a profit. After opening the trade the price drops to 3.3. The position has gone against the trader and so the trader decides to place another bet by laying the same amount as before. Their combined position is now for twice the initial bet but at a combined odds of 3.4 (3.5 + 3.3 / 2).

The trader still has a losing position as their combined price is still above the current price. Only if the price moves two ticks up will they be able to scratch the trade or 3 ticks for a 1 tick profit. If the price move is downwards on information that made the initial price good value then it will take future negative information to push it back out again. Can our trader predict the coming of new information be it good or bad?

By doubling the stake in the hope of improving their position the trader is "doubling down" (a term taken from Blackjack and used in financial markets). This is a Martingale strategy, which is a quick way to lose your money (see Martingale). What if the horse is now highly fancied by the crowd? The price falls further and the horse becomes a strong favourite. Do you continue averaging? Remember, you are laying the horse to lose and now the market thinks the horse will win.

You continue averaging, you let your bets ride when the race starts and you see the price heading inexorably towards 1.01. Were you right to average? Should you not have closed your trade with a stop loss or reversed your trade and backed the horse instead? Sometimes, it can be hard to admit that you are wrong.

The only circumstances where this trade can work is if the trader has superior knowledge to the crowd. The only knowledge that is superior to the crowd is inside or non-public information. Do you have that information? If our trader is convinced that his non-public information is correct and that the price of the horse is greater than its current price then that is the only reason to double down.

In conclusion, averaging as a method for getting back a loss is a Martingale and is to be avoided. On the other hand if you know that a price is not as it should be and increasing your stake, should the price go more in your favour, could be a good strategy. But remember it is your knowledge against the crowd and you better be right in the long run.