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Averaging down stocks is a an investment strategy that can potentially pay off with high rewards, but it is also high risk. Learn how averaging down works and how to calculate your breakeven point with examples, as well as reading about the pros and cons of this strategy, and, ultimately, finding out when you should and shouldn’t employ it.
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- What is the averaging down stocks strategy and how does it work?
- What is an example of this strategy?
- What are the advantages?
- What are the disadvantages?
- When might an investor employ this strategy?
- When is this strategy not a great idea?
- How to average down on stocks
- What are the alternatives to this strategy?
What is the averaging down stocks strategy and how does it work?
The averaging down stocks strategy involves making an initial investment purchase and then buying more of the same stock at a lower price if it drops from the purchase price. Investors generally use an average down strategy based on the logic that if they liked the stock at a higher price, the stock is an even better deal at a lower price.
Buying more shares at a lower price also reduces the breakeven point of the overall trade. The shares purchased at the lower price start making money if the price rises above it. This offsets the loss of the shares purchased at the higher price.
The goal of this strategy is to average down on stocks and then sell at breakeven. However, averaging down assumes that the stock will go back up. That sometimes happens, but not always. Also, it is unknown when the stock will go up.
What is an example of this strategy?
Assume that an investor or trader buys 100 shares of stock at £355 apiece. The price then proceeds to fall to £330. The investor or trader still likes the stock and, therefore, decides to buy another 100 shares at a lower price.
Use the average down stock formula below to calculate the new breakeven price:
[(# of shares x purchase price) + (# of shares x second purchase price)] / total # of shares
[(100 x £355) + (100 x £330)] / 200 = £342.50
If both purchases are for the same number of shares, add the two purchase prices and divide by two. If you have different quantities of purchases, use the formula above.
The average price for buying the 200 shares is £342.50. This is also the breakeven point. If the price rises to £342.50, the investor or trader will have zero loss or profit. Any price above £342.50 will show a profit, and if the price is below £342.50, the position is losing money.
What if the trader purchased 100 shares at £355 and then 200 shares at £330 (see the relevant calculation below)?
[(# of shares x purchase price) + (# of shares x second purchase price)] / total # of shares
[(100 x £355) + (200 x £330)] / 300 = £338.33
In this case, the breakeven point is now £338.33. It is lower because more shares were purchased at a lower price than at a higher price. As the price rises above £330, the 200 shares purchased at that amount start making money, offsetting the loss of the shares purchased at £355. Once the stock price moves above £338.33, the position is in profit.
What are the advantages?
Averaging down can get a trade back to breakeven or into profit quicker than if the strategy wasn’t used, assuming the stock price rises after adding to the position.
If the stock price rises after averaging down, large profits are possible since additional shares were purchased at a lower price. Essentially, the trader has the chance to profit on the original position, plus the additional shares they purchased at lower prices.
Averaging down provides a way to exit a trade at a lower breakeven price, compared with not averaging down — although this still requires the stock to bounce back higher. This may or may not happen. Averaging down and then selling to breakeven is a common reason why people employ this strategy.
What are the disadvantages?
Stocks don’t always bounce after buying or averaging down. Stocks can fall for extended periods of time, can fall a long way, or may never get back to their former price levels.
Even if a stock does eventually bounce, you can’t know for sure when that will happen. A stock could decline or move sideways for months or even years, tying up your capital.
Buying more of something that is dropping means giving up the opportunity to buy something that is performing better.
Averaging down can result in large losses if the stock doesn’t bounce and keeps dropping.
Adding to a position as it declines may mean the trader doesn’t have a sound risk-management method, such as using a stop-loss order or exiting when the stock falls by a certain amount.
When might an investor employ this strategy?
Longer-term investing strategies generally benefit the most from averaging down. This is because of the long-term investment horizon on trades and mostly applies to stock index funds, as these tend to rise over time. For any single stock, that may not hold true.
Passive investing can also take advantage of averaging down at times. Here, investors will regularly purchase index exchange-traded funds (ETFs) as the price is dropping. This can be effective because the investor has a long-term approach and will buy at set intervals.
Short-term traders may also wish to average down, but this is more of a gamble because there is no way to know if the stock will bounce. This is the exact reason why a trader may decide to employ this strategy: They have already purchased the stock, it is trading lower, but they still think it will move higher.
Another reason why traders employ this strategy is to average down stock and then sell to breakeven. The breakeven cost drops as more shares are purchased at lower prices. This is also a risky gamble because the trade no longer has profit potential (if sold at breakeven). There is also a big risk that the price will keep dropping.
When is this strategy not a great idea?
For stocks in long-term downtrends, averaging down may not be a great idea as it is hard to time when the bottom will occur. If something has been falling for months or years, there is no reason why it shouldn’t fall for even longer.
Averaging down with leverage is also unwise. If the price continues to move against you, you may receive a margin call before the trade has a chance to bounce. You will either need to deposit more money or be forced to close out the position at a loss. To avoid margin calls and large losses, understand how to invest in stocks without leverage.
For short-term traders, such as swing traders and especially day traders, averaging downmay not be ideal, as the price may not bounce within the timeframe needed. Stock prices can easily drop for an entire day, or even for multiple days, with little bounce.
How to average down on stocks
- Consider if now is a good time to invest. Consider buying stocks when they are at a lower price.
- If the price goes up after your purchase, then you can avoid the potential pitfalls of averaging down.
- Monitor the performance of your investments.
What are the alternatives to this strategy?
There are some alternatives to averaging down:
Consider exiting losing trades quickly at predetermined levels and re-buying when conditions improve/the price starts rising again.
You could plan for multiple purchases. For example, let’s assume that you want to buy a stock around the £50 mark. If you plan to purchase one-third of the position near £50 and it drops to £40, you could buy another one third and if it drops more, you could buy the other one third. In either case, your average price would be near to or better than you originally wanted.
Consider investing in many different stocks or ETFs. Decide how much you will put into each one and leave it at that. People who average down are often highly focused on a single stock and have too much invested in it already. Avoid that situation by spreading your capital around.
A buy the dip strategy assumes that prices will fall a certain amount. It’s then that the investor will make a purchase. This is different from averaging down, which is often done at random without statistics to back up the purchases.
FAQs
Is averaging down on stocks a good idea?
Only in certain cases. Most people average down assuming a stock will bounce. While this may happen, the further a stock falls the harder it is to get back to breakeven or into profit. That said, over time, stock indices do tend to rise, so with a long enough time horizon, averaging down may pay off for long-term index ETF investors.
How can I manage my risk when investing in stocks?
Consider the use of a stop-loss order. This is a sell order that exits the trade if the stock drops a predetermined amount or reaches a predetermined price. Also, consider only risking a small percentage of the account on any single trade.
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