Traders often engage in downside averaging to moderate, if not fully recover, unrealised losses on their existing position. This week, we discuss why downside averaging is not uncommon and the difference in averaging with options instead of with an underlying.
Downside averaging is an outcome of several behavioural biases. For one, if you go long on an underlying or its option and the underlying declines, you face unrealised losses. We hate losses. So, we trick ourselves into believing that if an underlying or its derivative was worth buying at higher price, it ought to be more attractive at a lower price. By averaging and lowering our cost, we hope to recover our unrealised losses. For another, we want to avoid the regret of having made a wrong decision. So, we actively look for evidence to support our initial decision, prompting us to conclude that the underlying could reverse its decline. We, therefore, add to our existing positions.
Downside averaging may not be optimal; the factors that led to your initial decision may have changed when the underlying moved in the opposite direction. It is less desirable with options. Why?
Options are wasting assets. This is because options have finite life. The time value of an option must become zero at expiry, captured by the option’s theta. Also, the delta of an option (the sensitivity of an option to a one-point change in the underlying) works against a long position if the underlying declines. Together, theta and delta are the primary reasons an option will lose value if the underlying price declines.
Suppose you buy the next-week 18000 Nifty call when the index is at 18006. If the index were to decline to 17900 the next day, the 18000 call could lose 63 points. You could reduce your total cost by going long on another contract of 18000 call at this lower price. But the objective of recovering losses through downside averaging will be achieved only if the index moves up the next day. If not, the increase in the option’s delta when the underlying moves up will not be enough to offset the initial loss and the continual negative impact of theta as the option approaches expiry. The above argument shows that time decay factor makes downside averaging with options different from averaging with an underlying. You should consider cutting your losses and closing your initial position.
Some traders consider going long on a lower strike call when the underlying declines- buying the 17900 call to add to the existing long position in 18000 call. Others convert the long call into a bull call spread to recover the unrealized losses. One way to moderate your urge to do downside averaging is to ask this question: Will you buy the 18000 call if you had not already held a long position on the option? If your answer is no, you should refrain from downside averaging.
The author offers training programmes for individuals to manage their investments. Views are personal