This is quite a risky technique and if used should be applied carefully with a well-developed plan. That is not to say there isn’t a place for this but it must never be done impulsively or in an attempt to rescue a failing trade
Averaging down was first applied by stock traders focused on fundamentals, not because of the price action of the stock (i.e. stock going against them).
When a fundamental trader did his homework and studied the company, the industry and so on, as he longed a stock and it kept doing down, the trader kept adding new long positions because “rationally” there was no reason for the stock to drop. They knew fundamental factors take more time to be reflected on the charts. Remember also fundamentalists do not have an objective methodology based on price to choose an entry level.
Edwin Lefèvre goes into a lot of detail on this in his famed trading book – “Reminiscences of a Stock Operator “. A highly recommended read! http://www.wiley.com/WileyCDA/WileyTitle/productCd-0471770884.html
The same is applied to currencies. When a currency pair has high interest rates, its country is generating jobs, the housing market was better than expected, etc. then there is no fundamental reason for such currency to go down. If the currency dips, then the trader might think the price is even better than it was before so he or she adds new positions.
Averaging down works as follows:
A trader decides to go long EUR/USD at 1.2000. The price of the euro keeps going down and as it hits the 1.1970 level the trader adds another lot. At this point the entry average of his or her trade is 1.1985 [(1.2000 + 1.1970)/2 = 1.1985]. Therefore, at 1.1970 this currency pair only needs to go back up 15 pips to break even (if he or she didn’t add to the trade, the market would need to go back up 30 pips in order to break even). The euro keeps going down, and when 1.1940 is hit our trader adds another position. The average entry price is now 1.1970 [(1.2000 + 1.1970 + 1.1940)/3 = 1.1970]. Now, the euro needs to go up 30 pips to break even, in contrast to the 60 pips if no averaging was done or 45 pips if our trader only averaged once.
At first glance, it seems the way to go, but what would happen if the euro keeps going down? The most probable scenario here is that our trader is caught up by the idea of improving the average entry price.
The worst part of this technique is that we don’t just “move” our entry level closer to the current price (this is what we usually focus on) but we double our losing position (this is what we refuse to see). In the example above, our trader ends up with a $300,000 size losing trade instead of a $100,000 losing trade. Therefore, we need to be really careful when we use this methodology.
We must avoid using this technique just because we want to improve our average entry price. If you decide to use this methodology it has to be a part of a well developed plan, in other words it must be part of your system.
This scenario looks like this:
The system of our trader signals a short trade. However, there is an important resistance level a few pips above the current price, so there is a possibility that the market goes up a little further to test the resistance level. Our trader opens the short position and decides ahead of time that if the market goes up to meet the resistance level, he or she will add one more lot. However, if the market breaks such resistance he or she will close all positions right away.
Under these circumstances averaging down is acceptable, because it was part of a well developed plan, however we still need to be careful because the market has started to prove we are wrong and probably isn’t a good idea to put more capital at risk. On the other hand, if you just want to average down because the price has gone against you, you are only making your losing position larger.
NOTE: Always take into consideration the RR ratio of the overall position. For instance, a trader longs the USD/CAD at 1.3090 and sets the stop loss level at 1.3060; an important support is just 15 pips below his entry price and decides ahead of time that if the market reaches 1.3075 he will add another lot. If the market goes down to the mentioned support level and our trader actually adds another lot, then he will have 45 pips at risk. This means that he will need 90 pips to make it to a RR ratio of 2:1.