What Is The Averaging Down Stocks Strategy And How Does It Work?
In order to acquire more of the same stock at a cheaper price if its price falls from the first investment price, the averaging down stocks approach first makes an initial investment purchase. On the basis of the assumption that if they liked the stock at a higher price, the stock is an even better deal at a lower price, investors typically employ an average down technique.
Because the average cost of the asset or financial instrument has decreased, the process is known as “averaging down.” As a result, the threshold for a trade’s profitability has also been lowered.
Purchasing more shares at a discount also lowers the trade’s overall breakeven point. If the price increases above it, the shares bought at the cheaper price begin to profit. As a result, the loss of the shares bought at the higher price is negated.
This technique aims to average down on equities before selling at a profit. Averaging down, however, makes the stock price recovery an assumption. Sometimes, but not usually, that occurs. Furthermore, it is unclear when the stock will increase.
For instance, if a stock was purchased at $50 per share and the price dropped to $40 per share, the investor would buy an additional 100 shares, bringing their average price (or cost basis) down to $45 per share. Some financial consultants advise investors to use dollar-cost averaging (DCA) or average down with stocks or ETFs they plan to buy and hold.
What are the advantages?
- Averaging down, presuming the stock price improves after adding to the position, can help a trade return to breakeven or turn a profit more quickly than if the method wasn’t applied.
- Large profits could be made if the stock price increases following the average down since more shares were bought at a lower price. In essence, the trader has the opportunity to make money on both the original position and the new shares they bought at a discount.
- In comparison to not averaging down, doing so allows one to exit a trade at a lower breakeven price, albeit doing so still requires the stock to rise again. This might or might not occur. People frequently use this tactic to average down and then sell at breakeven.
What are the disadvantages?
- After buying or averaging down, stocks don’t always rise. Stocks may decrease for lengthy periods of time, a great distance, or never return to their previous price levels.
- You can’t predict when a stock will bounce, even if it does eventually. A stock’s downturn or sideways movement could last for weeks, months, or even years, locking up your money.
- If the stock doesn’t recover and keeps down, averaging down might lead to significant losses.
- When a trader adds to a position as it loses value, it may be a sign that their risk-management strategy is weak, as opposed to utilizing a stop-loss order or leaving when the stock value drops by a specific amount.
The advantages of averaging down are often greatest for longer-term investment schemes. This is due to the long-term investment horizon on trades, and it primarily applies to stock index funds because they have a propensity to increase in value over time. That might not be the case for any particular stock.
Depending on the circumstances, averaging down can be a smart move. If the price of the specific asset rises, the initial trade’s profitability has increase and your average entry price has dropped.
But if the asset’s value later declines, the loss from the initial trade has grown much more. This is why traders disagree on the issue of whether averaging down is a good technique.