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Written and copyright © 2010 by Thomas N. Bulkowski. All rights reserved.
This article discusses averaging down, what it is and when it should be used.
What is Averaging Down?
Imaging that you bought 1,000 shares of a stock for $10 and now it's trading at $8. If you buy another 1,000 shares at $8, you can lower your average purchase price. That is,
($10 + $8)/2 = $9, which is now the average cost.
Averaging down means buying more stock at a lower cost to drop the average purchase price in the belief that when price rises, you can
make more money.
That makes sense, and it's true, but there's a catch. Price has to rise after you average down.
How many times have you bought a stock, threw more money into it after it
plunged, and then watched it continue sinking like the Titanic? You eventually threw up your hands and dumped the dog, shortly before the stock began to recover.
In other words, averaging down can be a costly mistake.
What about the optimistic view? Say you buy a drug stock and then they announce that one of their drug trials has flopped. The new drug cures the disease, but it has a side effect.
It kills people!
The stock drops in half. You still like the company, so you buy more shares, dropping your average purchase price. A month later, another company offers to buy the drug maker on the
cheap and price doubles. Yippee! You're rich!
Most times, of course, it doesn't happen like that. When averaging down works, it only does so because you're willing to hold the stock long enough for it to recover. And
therein lies the secret to averaging down. You have to hold on long enough for the stock to recover without it going bankrupt first.
Who Should Average Down?
The following table can help you decide if you should average down or not, and how to reduce the risk that the stock will continue dropping. Here are some definitions first.
- Buy and hold means a person that owns a stock, often for years. They are not interested in trading the stock, only for long term appreciation.
- A position trader is willing to own a stocks for months until signs of a major trend change becomes apparent.
- Swing traders capitalize on the move from trend (swing) low to trend (swing) high, or the reverse. Hold time is short, often weeks to months.
- A day trader exits each position before the end of the trading day.
| Trading Style | Should You Average Down? |
| Buy-and-hold | Yes, but do so carefully in a bull market. Check your holding to make sure the fundamentals are still sound and the technicals are appealing.
Fibonacci retracements work well in these circumstances. Measure the prior rise from swing low to high and average down at the 62% retrace of that swing move.
If it's a
bear market, then wait. Otherwise it's like catching a falling knife. You can get quite bloody in the process. Why take a chance? Wait for the markets to turn up. |
| Position trader | Yes, but you have to hold long enough for the stock to recover and only in a bull market. Make sure the industry is also rising and any problems
with the company are due to short-term factors (like a bad quarter with rosy projections for the next quarter). |
| Swing trader | Probably not. If you're too early, expecting a turn and the stock is continuing to drop, then average down if market and industry are rising and do so only once.
If you want to average down a second time, sell the loser instead. Remember, you're supposed to be a pro. Admit your mistake, take the loss, and move on.
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| Day trader | No. As a day trader, you have to exit by day's end and there is no guarantee that the stock will rebound by the close. Never let a day trade turn into
a multi-day holding. One trader I know lost half his account that way. |
-- Thomas Bulkowski
Written and copyright © 2010 by Thomas N. Bulkowski. All rights reserved. Stealing a rhinoceros should not be attempted lightly.
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