Double Down Trading Strategy — Concept and Backtest Findings

A trader in a losing stock position has only a few options: they can close the trade at a loss and look for opportunities elsewhere; they can hold the losing position for a while and hope that the price will turn around and get to their entry price, which may take a long time if it happens at all; or they could decide to use the double-down strategy. What does the double down trading strategy entail?

The double-down strategy is a stock trading strategy that entails adding another position to a losing trade, with the hope that the reversal will help you recover your losses. It involves doubling your position when the stock price falls in order to improve your average order entry price.

In this article, we show in backtests when a double down trading strategy works or not works. Let’s go a bit deeper.

What is a double-down trading strategy?

The double-down strategy is a stock trading strategy that entails adding another position to a losing trade, with the hope that there will be a reversal to help recover the losses. It involves doubling your position when the stock price falls in order to improve your average order entry price.

In the case of a losing long position, it means buying the same number of shares as the initial position as the market goes against you with the hope that the price would rise again so you can break even if the price recovers just half the suffered decline.

To understand the double-down strategy, we will use an example:

Let’s say you bought 100 shares of Amazon stock at $136 per share and then the stock price dropped by $36 to $100 per share. You may consider the loss unacceptable and refuse to close your position at a loss.

In that case, you can hold and hope that it recovers, which may take a long time. If you want to break even as early as possible, you may choose a double down strategy by buying another 100 shares of Amazon. If the stock reverses and appreciates by $18 (half of the decline), you will already be at breakeven because the loss on the initial 100 shares has reduced to $18 per share while at the same time, the second 100 shares have gained a profit of $18 per share. This is the essence of a double down trading strategy.

However, it doesn’t always work like that — the stock can keep declining after you buy the second position. With the double-down strategy, you sometimes throw money after a bad trade in hopes that the stock will perform well.

Is the double down trading strategy rational?

The “problem” with a double down trading strategy is that you focus on the price and not the odds of succeeding. In trading and investing, you need to focus on the process and the odds for success. The market doesn’t care about your average price and goes wherever it likes. Thus, the average price is often a mental bias, some kind of anchoring. Is a double down strategy part of your overall strategy? Always keep this in mind!

A double down trading strategy might be somewhat similar to a scale-in trading strategy. For example, if you are buying Amazon you might not use all your capital on the first buy but have additional capital on the sidelines if Amazon’s price drops further. However, the difference is that a scale-in strategy is a planned course of action, while a double down strategy rarely is.

Is the double down the same as the Martingale strategy?

While the double-down trading strategy may look similar to the Martingale trading strategy, they are not the same. In the double down trading strategy, you add the same position size as the initial losing position, but in the Martingale strategy, you add a larger trade size (double the initial position) after each loss. As a result, the Martingale strategy increases your risk substantially more compared to the double-down strategy.

Is the double down strategy the same as the repair strategy?

No, they are different, even though both are aimed at achieving a faster breakeven. The repair strategy involves the use of call options to repair a losing position — you buy one call option and sell two call options for every 100 shares of stock owned. The premium you get from the sale of two call options is enough to cover the cost of the one call options, so you end up with a “free” option position that lets you break even faster.

Double down strategy and mean reversion strategies

Mean reversion strategies tend to work like rubber bands: if the price goes above or below the “normal price” it tends to move back to the average (revert to the mean). Thus, a double down trading strategy might work well. Please read our double down trading strategies further down.

Double down and trend following strategies

Opposite to mean reversion strategies, we find that trend following strategies might not work with a double down strategy. Please read our double down trading strategies further down.

Double down trading strategy (backtest and example)

Let’s go on to backtest some double down trading strategies with specific trading rules and settings.

We start with mean reversion double down:

Double down – mean reversion trading strategy

As mentioned above, a double down strategy might work well in assets that tend to revert to the mean. Stocks are such an asset; mean reversion has worked well for about three decades.

Let’s make the following backtest on SPY (the ETF tracking S&P 500 – the oldest ETF still trading):

Trading Rules

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The equity curve looks like this:

There are 518 trades, and the average gain per trade is 0.56%.

Let’s do a double down strategy and enter on the following trading rules:

• We go long at the close when the 2-day RSI indicator crosses below 10.
• We sell at the close when the 2-day RSI indicator goes up above 90.

The equity curve looks like this:

There are 236 trades, and the average gain per trade is 0.97%. The reduced number of trades makes less money overall, but all the trading strategy performance metrics improve.

What do the two backtests reveal? The more it falls, the bigger the expected gains. This strongly indicates that doubling down works well in mean reversion strategies. However, only one big loser can create havoc – even ruin you.

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Double down – trend following trading strategy

Let’s switch to another asset that doesn’t mean revert but instead tends to trend: junk bonds. Junk bonds tend to follow stocks (and not bonds) but still trade differently: they tend to trend and not revert to the mean (at least in the short run).

As a proxy for junk bonds, we use the ETF with the ticker code HYG. It’s a highly liquid ETF.

We backtest the same trading rules as we did with SPY and mean reversion in the example above.

The equity curve of backtest 1 looks like this in HYG:

There are 275 trades and the average loss per trade is 0.19%.

Let’s look at what the equity curve of backtest 2 looks like:

There are, as expected, fewer trades (125) but the average loss per trade increases to 0.22% per trade.

While SPY increases the average gain when doubling down, the opposite happens in trend-following assets: the average gain/loss worsens, thus indicating that a double-down trading strategy is a bad idea in many assets.

Double down trading strategy – ending remarks

This article has shown that a double down trading strategy sometimes works and sometimes does not: it tends to work in mean revertive assets and not in trending assets. However, a good trader is able to distinguish when it might be wise to double down and not. That said, doubling down is rarely part of a rational trading plan but is often a trading bias.

FAQ:

When should traders consider using the double-down trading strategy?

The double-down strategy involves adding another position to a losing trade with the hope of recovering losses. It includes doubling your position when the stock price falls to improve the average order entry price. Traders might consider the double-down strategy when facing a losing position and expecting a reversal. It’s essential to assess the market conditions and potential for recovery before implementing this strategy.

How does the double-down strategy differ from the Martingale strategy?

The double-down strategy may focus on price rather than the odds of success. It’s crucial to consider the overall trading process and odds for success rather than fixating on the average price. While they may seem similar, the double-down strategy involves adding the same position size, whereas the Martingale strategy adds a larger trade size (double the initial position) after each loss, substantially increasing risk.

What are the risks associated with the double-down trading strategy?

The double-down strategy carries risks, especially if the market continues to decline after implementing the strategy. Traders should be cautious about potential losses and have risk management strategies in place. Doubling down is rarely part of a rational trading plan and is often driven by trading bias. A well-thought-out trading plan should focus on overall strategy, risk management, and probability of success.