Average down stock strategy is the process of buying a stock at each lower market price to bring average buying price lower.Is it a right strategy for you?
There is a simple motto to make money in stock markets. ‘Buy Low and Sell High’. That means you buy shares at low market prices and sell them when the price reach higher levels. The difference between your selling price and buying price makes your profit.
But, is this formula really that easy to apply? Unfortunately it is not so. Suppose a trader or an investor buys shares at a particular price. The share prices go lower down further. Next thing to come to his/her mind may be to average down the buying price by buying more shares at those prices. This way he is putting more of his money to market risks.
It is the novice traders and investors who are usually caught on wrong foot by this strategy. Although it is not uncommon to see even the experienced people face such a situation buy they are able to manage their money and risk well, thanks to their experience of financial markets.
What is Averaging Down Stocks Meant By?
Averaging Stocks is the process of buying a particular stock in small instalments each time it falls to lower prices. The purpose is to bring buying price lower by averaging of all buying price levels.
Suppose an investor buys 100 shares of a company at ₹ 100 for a cost of ₹ 10000. If the share price slips to lower support of ₹ 80, he may choose to buy another 50 shares at that price with cost of 80 X 50 = ₹ 4000. If stocks falls further to next support of ₹ 60, he may buy another 50 shares with cost of ₹ 3000.
Now he holds 200 shares with a total investments of ₹ 17000, with buying price coming down to ₹ 85 per share from previous ₹ 100 per share. This way he has averaged down his buying price by adding more shares to his portfolio.
Different market experts have different opinions regarding Averaging Stocks when asked. Some are strictly against averaging down stock strategy while some advice in favour of it. They have their own reasons to support that.
Should You Go For Average Down Stock Strategy ?
What should be your strategy if you face such a situation? You need to be learnt enough to deal with it appropriately. Although professional advice is a welcome but even then it is your own money and you should be prepared to manage it accordingly. Someone other can’t take best decision regarding your money than you yourself. You are the one who knows your risk profile well.
Decision of going for average down stocks should be based on two parameters – Your Profile and the Stock Profile of the stock you are planning to average down.
First thing to do is to identify yourself if you are trader or an investor. If you are a trader, averaging should be avoided until it is a part of your trading strategy which you are following even before taking first exposure to the stock. We would take it in bit detail in Stock profile.
A trader has a smaller time frame to keep trading position open. So adding to a losing trade without a proper trading plan only piles up losses.
An investor is willing to give investments long times so that there is a probability of turning the investment profitable with time. An investor may add to existing position in small amounts with each fall of minimum 10-15% if the stock has good fundamentals.
You can study the stock profile in two ways :- Fundamental Analysis and Technical Analysis
Fundamental Analysis tells us how strong the foundation of the company of that stock is. Stock with good and strong fundamentals are expected to do well over longer time periods. Even if they fall significantly, they have the potential to bounce back strongly when favourable market conditions return.
It is less risky to average down the shares of fundamentally strong company if you are an investor. Even if you are not a Fundamental Analyst, you can know about the company by reading the current news if it is facing or not any troubles which may affect it in the long run.
If you average down such stocks, it brings your buying price low. Consequently, the rewards are big when the stock starts recovering.
It is important not to get panic by watching daily price fluctuations. As an investor, you can keep reviewing your investments every six months or annually.
Technical Analysis tells us about short term market moves based on technical charts. If you are taking your trading or investing decisions based on the technical analysis, it becomes much easier to decide if you should go for averaging or not.
By Technical Analysis, we get to know about the Support and Resistance levels in stock prices. We may look to average down to our trading position when the stock reaches near a support level in a downfall.
Stocks have the tendency to bounce from the support prices. That helps averaging to work in our favour. So you can use it as one of your stock trading strategies.
But it is important to keep in mind that you are not averaging stocks with each tick fall in stock prices.
Not being aware of the technical profile of the stock may lead us to buying below the Support level where the stock mat head lower to next Support. This will pile up the losses.
You can keep the provision of Averaging Shares while making a trading strategy. Suppose you wish to trade a stock which is trading 2-3% away from the Support level and markets are in upswing. You can’t trade with full capital at current price because you fear stock testing support after you enter the trade. You also fear off missing the trade as markets don’t look like coming lower.
So you may decide to trade with say 50% of your capital at current price. If markets turn volatile and come down, you may average your buying price by buying near support level with the rest of 50% or 25%.
Points To Remember While Averaging Down Stocks
- Look to Averaging Stocks of fundamentally strong companies only or the companies you believe may do well in future.
- As with investing, Averaging should be done with surplus money only which you can expose to market risk and don’t need in near future.
- Take the help of technical analysis and Average out shares near their support levels only.
- Never Average Shares of a fundamentally weak company. You may choose to book the losses and exit out of it if the loss is not significant. Otherwise you may leave it for long time investment hoping to recover it on some improved environment if the losses are much higher.