For those who don’t know, “averaging down” is when you buy a position in a stock at a lower price than you initially bought it for. So, if you took an initial position of 1000 shares in a stock at a price of $5, and later purchased another 1000 shares when the stock dropped to $4, you would be averaging down to $4.50/share. Many investors have different views on averaging down. Some think that it is a great way to get cheaper shares in a company you believe in, while some think that you are buying into a stock when the momentum is against you. I agree with both arguments and utilize a hybrid strategy.
First things first, you need to know how your stock trades. Stock price movements are largely controlled by the public sentiment surrounding the stock. This is why stocks can run on a press release or mere speculation. If you follow a stock for awhile, you should begin to develop an understanding of the sentiment surrounding the stock. When public sentiment is positive, the stock will rise. When public sentiment is negative, the stock will drop. I’ll go into how you can gauge public sentiment in a different post.
So, let’s get to the averaging down strategy. It’s nothing complex or revolutionary, but it does help me save a lot of money. When I recognize that there is negative sentiment surrounding a stock, I realize that the price will not move upwards. At the very best, the price will move sideways. When a stock is trading sideways, all it takes is one large seller to panic the market and create a breakdown. At these times, I will sell all or some of my current position for a small gain or small loss. I will then repurchase all or some of my position in the stock when it reaches new bottoms.
Let’s take the example I gave earlier where you purchase 1000 shares of a stock at $5. The stock may be trading in a range of $5-$5.50 for a few days without any signs of a spike in share prices. Without any catalysts, the stock will move not move up, and sideways action can test investor confidence. Whenever I see investor sentiment shifting, I plan to start averaging down. If I catch on to the drop early, I will sell for a small gain in the lows of the range at around $5-$5.20. If I don’t catch on soon enough, I will sell for a small loss between $4.50-$5. When the stock drops back down to $4 (let’s assume this is the bottom), I will repurchase my position.
Compare this to a standard “averaging down” tactic:
Standard Averaging Down Strategy –
Buy 1000 Shares at $5 > Stock drops to $4 > Buy 1000 Shares at $4.
You now own 2000 shares. Assuming the price stays at $4, your loss is $1000 until price movement shifts upward.
My Strategy when I catch on to a drop early (Best case scenario):
Buy 1000 shares at $5 > Sell shares at $5.20 ($200 profit) > Price drops to $4 > Buy 2000 Shares at $4.
You now own 2000 shares. Assuming the price stays at $4, your profit is $200 until price movement shifts upward.
My Strategy when I catch on the drop in realtime (“Worst” case scenario):
Buy 1000 shares at $5 > Stock starts dropping > Sell at $4.50 ($500 loss) > Price drops to $4 > Buy 2000 shares at $4
You now own 2000 shares. Assuming the price stays at $4, your loss is $500 until price movement shifts upward.
Standard Averaging Down Strategy = $1000 Loss
My Strategy (Best Case Scenario) = $200 gain
My Strategy (Worst Case Scenario) = $500 loss
By utilizing my strategy, I can cut losses and even take some gains. Of course, these numbers are fictional, and getting orders filled doesn’t always work as well in practice as it does in theory, but the concept remains the same. Why hold onto a stock as its dropping when you can buy back your exact position for a cheaper price? The key to making this strategy work is to have some sort of foresight into the stock’s price.
Other things to note:
- A more experienced trader may want to consider shorting the stock on the way down to profit from the drop.
- If the stock is dropping based on a catalyst other than public sentiment, you may want to reconsider your reentry.
- Only re-enter the stock if you believe it will move back up again. This works better for people who are truly long on a stock but don’t want short term volatility to hurt their portfolio.
- Look for bottoms. An ideal re-entry is at the stock bottom. This strategy can still help if you don’t find the exact bottom, but buying at the bottom is much better.