Averaging down is a trading strategy investors and traders use when they are trying to lower the average cost per share. This means that as the price goes lowers, investors buy more shares. In the end, the cost per share goes lower and lower which follows the trend of the price movement.
The main purpose of this strategy is to minimize the unrealized loss. This means that as you lower the average cost per share, a small rebound could bring the price close to what you spent. Hence, reducing your loss per share, break-even, or make a profit.
In this article, we will examine why averaging down is not a good strategy for many traders especially inexperienced ones. Keep in mind that long-term investors should not worry much about averaging down since short-term fluctuations do not matter.
Before we get into the dark side of averaging down, we will examine how it works with an example. We will also see how a trader can successfully execute this strategy to minimize his/her loss and hopefully make some profit.
Example of averaging down
To understand how averaging down strategy works, we are going to use an example. Please, refer to the chart and interpretation below.
Let’s assume that you took a long position in the stock as seen on this chart. You bought 100 shares at 4.60 per share. This transaction cost you a total of $460. As you know, the market is not always predictable. So, the price went lower and lower.
In an effort to manage your loss, you decided to average down. So, you bought 100 more shares at $4.05 share. This transaction cost you $405. Your total cost so far is $865 ($460+$405). The stock plummeted much lower and you ended up purchasing 100 more shares at $3.60 per share at a total cost of $360.
Your new position size is now 300 shares at a total cost of $1,225.
With a little bit of luck, the stock went back up and you decided to sell and exit your entire position. All your shares were sold at $4.10 per share.
Now let’s see if you made or lost money.
As you averaged down, the overall cost per share became $4.09 per share. To calculate this average, just add all your money and divide the number of shares you purchased in the company. You can follow this link and learn how to calculate the average for more details.
Did you make money or you lost some on this trade?
By selling 300 shares at 4.10 per share, you took home a total of $1,230 ($4.10 per share X 300 shares).
The total investment cost you $1,225 as we have seen it from the above calculations.
Your return on investment (ROI) = $1230 – $1,225 = $5. So, you made a net profit of $5 on this trade assuming that you paid no trading commission.
Now, let’s see how much you could have made or lost if you decided not to average down and sold your shares at $4.10.
Since you did not average down, you will only have 100 shares which you acquired at $4.60 per share. Selling these shares at $4.10 per share brought in $410 (100 shares X $4.10 per share).
Your ROI = $410 -$460 = -$50. So, you lost $50 on this trade.
There are chances that you could have sold much earlier which could have reduced your loss.
The point here is that by averaging down, you were able to minimize your loss and turned a losing trade into a wining one.
Why is averaging down a bad strategy?
In the example above, we only looked at a situation where a trader systematically bought shares in a stock and was able to get out at the right time.
That is we only focused on a winning scenario.
What if the stock did not go up? This is a very good question to ask yourself when trading regardless of whether you are averaging down or not.
Before we move to what could go wrong with averaging down. I want to point out what exactly happens when you are averaging down.
In our previous example, we started with 100 shares, then added 100 more shares, etc. In order words, our position size increased as we buy more shares.
By increasing your position size, you also increase your risk. That is averaging down is a strategy that helps you minimize your loss but also increases your risks at the same time.
Short term trading (day trading and swing trading) strategies help investors and traders to benefit from short-term price movements.
That is you can get in and out of a stock in a day, two days, weeks, etc. This means that your short-term loss could be detrimental if you expose your portfolio to higher risks.
To avoid wrecking their trading accounts, traders exit their positions at manageable losses.
Back to our main question. What if the price did not go back up in the example we discussed above? What if the price continued to do down.
Could you continue to add more money to the stock? Or could you sell and lock in a loss? The answer to this question will depend on your risk tolerance and how much money you have at your disposal.
Some traders and investors will tell you to sell. Others will tell you to add more money.
Adding money to a losing stock? Bad idea
The truth is that adding more money into a losing stock increases your risks even more. That is your loss will be maximized if the price does not rebound.
What if the price continued to decline and the trader we discussed in the chart above decided to exit their trade.
Since the last purchase was made at $3.60 per share, we will assume that the stop-loss order was placed below that value. Let’s assume that the trader was willing to lose only 10 cents per share after the last purchase. This means that the stop-loss order was placed at $3.50.
A stop-loss means that your broker will sell the number of shares you specified at the best market price possible once the stop loss is triggered. To make matters simple, we will assume that all shares were sold at $3.50 per share.
Selling 300 shares at $3.50 per share brought in $1,050. Now, lets calculate how much the trader lost on this trade.
ROI = $1,050 – $1,225 = -$175. So, the trader locked in a net loss of $175 on this trade.
This means that a small loss ($50 loss) turned into a huge loss ($175 loss).
Should you average down?
Although you could reduce your loss by averaging down, this is not a good strategy to consider especially when you are new to markets. This is a strategy that increases your losses and exposes you to more risks in the market.
Should the stock you are trading continues to plummet, you will be forced to exit your position. Hence, locking in a huge loss that could have been avoided.
If you are an experienced trader or investor, apply this trading strategy cautiously. You must use loss prevention methods and exit your trade before it is too late.
However, if you are new to markets stay away from averaging down. This is because a successful trader is the one who can make sense of the market and predict the possible direction in the price based on proven methods. New traders do not have such experience and expertise.
For this reason, averaging down only increase risks to new traders.
Always remember that a single trade can send you back to work two full time jobs!
Now that you know why averaging down is a bad idea; How can you avoid it?
What should you do to avoid averaging down?
The best strategy to use for short-term traders and investors is to have a plan. That is you should know how many shares to buy at what price, your profit-taking strategies, and more importantly, your risk management.
People who fail to plan are those who find themselves at the mercy of market volatility.
You should know how much money you are willing to lose on every single trade. For example, you can decide how many cents you are willing to lose per share or the total dollar value. This will guide you to placing your stop loss at the best price possible.
Always use a stop-loss order on every trade you make. A stop-loss order will kick you out of the market if the price moves in the direction you did not anticipate. Once you are out of the market, you will not worry about averaging down.
Never add to a losing position. Instead, get out of the stock before it is too late.
