Averaging down is the popular way to describe buying more of a position as a stock goes down. It’s akin to seeing something you think is valuable in a supermarket getting marked down over and over again. And because you believe it is undervalued, you buy more of it as the price plummets.
But is the averaging down trading strategy profitable over the long-term? How about when day trading? What are the pitfalls?
In this post, we will cover the basics of the averaging down trading strategy and why this approach can be dangerous for your portfolio. We’ll also look at why “averaging up” on a short position can be even more dangerous. Lastly, we’ll give an example of when averaging down might work.
What is Averaging Down?
Averaging down is the process of adding to a position as it goes counter to your initial transaction. You can also “average up” in a position when you are trying to short it. In other words, you sell more shares short as the price rises — moving your average price up as you go.
In theory, this makes sense because it will allow you to obtain the same asset at a better price. Therefore, you can average down or up on the entry price and, in turn, increase the profits when you close out the position.
That being said, there is one major flaw in this strategy. You have no clue which trades will go in your favor and which will continue to slide against you.
A Competing Theory
Opponents of this strategy point to the old adage of cutting your losers and letting your winners run. This sounds easy enough, but why is this so hard to do?
The answer to that question is rooted in the fundamental human nature to hope. Just like other parts of our ordinary lives, we tend to want to hang on to things too long, hoping they’ll change for the better.
For this reason, when we see a stock is no longer going in our favor, instead of taking the loss, we do what we think is the “smart” thing and add to the position. It’s all based upon our ego and not wanting to be wrong.
Yet while change may inevitably come, all too often that hope may take us on a ride far longer and more costly than we ever imagined.
If you can accept a loss for what it is, then trading becomes one of the most straightforward business operations you could ever undertake. But instead of treating our trades like a business decision, we get stuck in the emotional attachment of holding on.
Investors use phrases like averaging down to justify their risky actions of not only holding onto a losing position but adding to them.
To understand the psychology of it all, let’s step back from the trading game for a second and look at the concept another way.
Would You Average Down with any Other Business?
To simplify the concept of averaging down, let’s say you owned a small housewares shop. In this shop, you sell all types of products.
But you recently added a new style of toaster that is going to change how people eat their breakfast.
Placing the toaster in your front window with banners and ribbons, you think the toasters will fly off the shelf. You believe in the product.
However, to your surprise, you were only able to sell one toaster in an entire week.
You look over your inventory sheet, and you realize that you have 499 toasters left to sell, so you begin to worry a little and place a phone call to the supplier.
Somehow Things Get Worse
The supplier empathizes with your concerns.
To help you out, they offer an additional 20% discount to improve your margins. This time, you know that things will be better because you can average down on the price you paid for the toaster.
Perhaps the only reason the toaster is not selling is due to the sale price.
With that in mind, you take the supplier up on their offer. You now own 1,000 toasters. 2/3 of your inventory are priced at the discounted rate — a better average price.
You mark the price down slightly, but to your surprise, there is no additional interest. You are still unable to sell any toasters.
What would you do at this point? Would you average down again?
Take a look at what this activity would look like on a stock chart. Imagine if these shares of Citigroup were toasters:
As you can see, trading is just like any other business. So, why expose your trading account to this risky behavior?
2008 Mortgage Crisis – Example of Averaging Down
For those of you that can remember the bear market in 2008, it was nothing short of brutal. The market fell off a cliff and just kept going.
As an investor, you may have decided to buy the Dow Jones as it was tanking. This is what it would have looked like:
As we all know, the Dow is now trading back over 30,000. However, it has taken 13 years to get there. Why not let others clamor for the bottom in pricing, while you pick up the pieces once they’re exhausted?
Only Average Down from a Position of Strength
This may sound a bit contradictory at first? Let’s explain.
A position of strength means you are buying into the dips of a strong trend.
You can get a better feel for the concept through chart illustrations. Let’s examine a few.
Comparing the two charts below, which stock would you want to average down on?
You are probably thinking, well you can’t average down in the first one because it’s at highs and showing real strength.
Well, that’s precisely what we want to see.
You just need to go to a lower time frame, like 5 minutes for example, to find an opportunity where you can average down in the stock. The $23 level was finding support on the daily chart, so we zoom into the 5min chart and place our “dip buys” there.
Remember, this stock was at multi-month highs on a daily chart. So, buying into this stock would be buying right as it is breaking out on an intraday and daily basis.
We call these constructive pullbacks. They are different from reversals and capitulations. Ideally, they occur in a young, strong uptrend, where we expect more highs.
This is how you buy from a position of strength.
To reiterate: averaging down can be very risky. But, if you are going to do it, you have to buy into a stock that is trending strongly.
Closing Trades You’ve Averaged Into
There are two choices you have when deciding how to close out your trades. Please review each approach in detail and think back to your trades to see which one will work best for you.
Close Out the Position in Pieces
If you fid yourself in the position of having averaged down on a trade, it may make sense to close the position out in pieces.
For example, if you had four buys into a falling stock, you would have the same four sells to exit the trade.
Now, this is where it gets a bit tricky.
If you are up on the position and you want to scale out as things go in your favor, this makes total sense. You are never going to go broke taking money out of the market as things go your way.
In the above chart example, you can see three entries and three sells. This scenario would be the best you can hope for with this approach.
Averaging down would have allowed you to gain a better average share price, while you are then later able to scale out of the position at much higher prices.
Again, this is assuming the entries were from a constructive overall pullback.
Two Things Required to Close Out in Pieces
There are two pieces to this puzzle you need in your favor.
Firstly, as you average down, you need the stock to hold up and not continue lower. In other words, a constructive pullback into an area of support like we mentioned earlier.
Secondly, the rally not only turns a profit for you but rallies strongly enough that you can sell out in equal pieces.
This even more challenging of a concept when you factor in day trading, as the morning high set within the first hour of trading is often the high for the entire day.
Again, this can be a risky trade if the stock doesn’t bounce. Imagine the example below:
In this event, how do you scale out of a losing position? Assuming you didn’t sell at the bottom.
This is where paralysis could set in and as stated earlier, you now take a massive loss as you are carrying a large position after averaging down and you are completely vulnerable.
Close Entire Position
If you are closing your entire position, you are doing so for one of two reasons: (1) you have hit your target price or (2) you are getting crushed, and your stop loss was triggered.
Hit Your Target Price
Buying from a position of strength means being in a stock that is going in your favor soon after your entry. This is ideal.
As we mentioned earlier, this typically occurs in a strong uptrend, or right after a constructive pause in that trend.
In these slow and steady stocks, it is easier to sit tight until your target is reached.
The benefit of holding your entire position until you reach your target is reaping all the profits at the highest price. The downside is you are completely exposed until your goal is reached.
Stop Loss Exit
This one typically hurts the most for amateur traders. But for experienced traders, it doesn’t hurt as badly.
Why?
Disciplined traders only put on trades when all their criteria are met. This doesn’t mean they have a 100% chance of success in the trade. It just means they have a high probability of success.
So when their stop losses are hit. They don’t take it personally. They chalk it up to the 15% of trades they know they’ll lose.
On the other hand, the amateur trader is averaging down during this process. And depending on how you averaged down will determine how much pain you are feeling as the stock goes against you.
However, like the professional trader, if you have a set amount you use on every trade and you scale in, then while you will take a loss, it may still be manageable.
Now, if you use a set amount per trade, but have gone beyond your standard per trade amount and have doubled or tripled your exposure when averaging down – you are in trouble.
Regardless of the amount of pain due to the loss, closing out the position at your predetermined stop is the right decision.
In Summary
Ultimately, averaging down or up is your decision as a trader. As we have recommended, if you are going to average down, do it from a position of strength.
Better yet, we encourage you to track your results over a minimum of 20 trades or more in a simulated environment.
See if averaging down has helped improve your bottom line before you put real money to risk.
Good luck!