Averaging is a debatable topic in trading. Unlike novice traders, professional traders typically avoid downside averaging. This week, we discuss upside averaging with futures and show why it can be a gainful strategy.
Price averaging
Downside averaging is tempting. Suppose you buy the near-month Nifty futures contract at 24641. If the price declines by 100 points and you decide to buy another contract, your break-even price declines to 2459. So, the argument is that if futures price reverses, your chances of closing your position with a no-loss no-gain is greater than if you keep your original long position open.
Upside averaging is a different argument. Suppose you observe that the futures price is trending up — the price is making higher highs and higher lows. Adding to your long positions will then be gainful. Suppose you add one contract for the next two 100-point moves in the future price — you buy one contract if the Nifty futures were to reach 24741 and 24841. Your average cost will then be 24741. Note that when you do upside averaging, your break-even price is below the current market price. In contrast, when you do downside averaging, your break-even price is above the current market price.
Now, suppose the futures price moves to 24950, your gain from upside averaging will be 15625 (627 points times 25 permitted lot size) compared with 7725 if you had kept the original long position open. Of course, your losses will be greater if the futures prices were to gap down or sharply reverse the uptrend. You should, therefore, add to the long position only if you are confident about the uptrend.
You also engage in upside averaging when you setup a systematic investment plan (SIP) on a Gold ETF or a Nifty ETF that is trending up. The primary difference is that you are not timing the entry and exit when you setup the SIP as you would when you are trading futures. Note that upside averaging with options is a different argument because options suffer from time decay. One reason upside averaging with futures could be gainful is because futures price typically moves one-to-one with the underlying.
Optional reading
Upside averaging strategy should be implemented after analysing price patterns, as the downside risk is large. A high probability setup would be when price pauses after an uptrend and briefly moves sideways before making a decisive break out — the breakout candle could be a large green candle with close at or near the high for the day. If you use price bands such as the Bollinger bands, an optimal setup would be the price bar breaking and closing the upper band on handsome volumes. Finally, note that trends are stronger in the commodity markets than in the stock markets. So, upside averaging can be more gainfully applied to commodity futures. It is important to have a trailing stop-loss to manage the position.
The author offers training programmes for individuals to manage their personal investments