Does Averaging In Work ~ forex swing trading strategies that work
Ron Schoenberg and Al Corwin recently did some interesting research on the trading technique of "averaging-in". For e.g.: Lets say you have $4 to invest. If a futures price recently drops to $2, though you expect it to eventually revert to $3. Should you
A) buy 1 contract at $2, and wait for the price to possibly drop to $1 and then buy 2 more contracts (i.e. averaging-in); or
B) buy 2 contracts at $2 each; or
C) wait to possibly buy 4 contracts at $1 each?
Lets assume that the probability of the price dropping to $1 once you have reached $2 is p. It is easy to see that the average profits of the 3 options are the following:
A) p*(1*$1+2*$2) + (1-p)*(1*$1)=1+4p;
B) 2; and
C) p4*$2=8p.
Profit A is lower than C when p > 1/4, and profit A is lower than profit C when p > 1/4. Hence, whatever p is, either option B or C is more profitable than averaging in, and thus averaging-in can never be optimal.
From a backtest point of view, the Schoenberg-Corwin argument is impeccable, since we know what p is for the historical period. You might argue, however, that financial markets is not quite stationary, and in my example, if the historical value of p was less than 1/4, it is quite possible that the future value can be more than 1/4. This is why I never make too much effort to optimize parameters in general, and I can sympathize with traders who insist on averaging-in even in the face of this solid piece of research!
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