Averaging Down – Forex Academy

I have seen in several forums that many investors practice the risky sport of averaging down. This strategy is nothing more than investing more money every time the stock/ ETF/ Fund, etc goes down, so we get a reduction in the initial cost by buying more shares at lower prices.

This strategy has several problems…

– Each time we average to lower the average cost we add more money, therefore we add more risk.

– “Money Management” or money management strategy is a martingale (I buy when I lose, that is when I lose). This strategy is perfect when our capital to invest is infinite, which is not very likely.

– It is not recommended unless you know how to do it, because if you do not do the strategy well or do not choose the underlying well, the losses can be very painful.

– We are invested in a broad ETF (there are many companies and good ones) and the ETF has downward swings because of the feeling of the market, and not because of the quality of the companies that compose it, so it is an inefficiency that we could take advantage of if we have liquidity.

– Exactly the same as the previous point but with an individual company. Here I have to say that you do not do it, do not lower your average in individual companies, unless you know how to read a balance sheet and trust very much in your judgment that the company is good and will continue to make profits.

If you still want to average down we’ll see how we can do it. The example I am going to give with a company, and this example can be extrapolated to an index. The company XZY is a large company, what’s more, I would say it is a very large company, with annual dividend increases of around 7% on average, improved margins has an impeccable balance sheet, etc, etc, etc. Ultimately a really good company with very little chance of going into losses, although this is never 100% reliable.

Once we know that the company is very good and its balance sheet is difficult to get worse enough we want to enter it to take advantage of its current price and be able to get quite good returns. The intrinsic value of the stock is €100, and it is currently listed at €60, so it is trading at a 40% discount. I think it’s enough of a discount to go in and have a good long-term return.

I have 10,000€ to invest in the value, and at 60€ I will buy 100 shares of the company, so I will invest 6,000€ initially. Now, because of the current market situation, because of the phase of the cycle in which we are, because the political situation of the country is this or that, etc… it is likely that the market will punish the quotation and we will see it below, even though it is an incredibly good company, which gives us the possibility to buy more shares (more risk) in exchange for lowering the average cost (more profitability) and when quoted at prices close to its intrinsic value, get a few more points of profitability.

Then let’s try to figure out what a super price would be. The super-price is the price at which the company is a very clear investment opportunity and will give us really good long-term returns. For our example I estimate that a super-price for the company is 40€ per share, that is, we shouldn’t care if it goes any lower, because at the price I buy the company, earns enough so that the money invested in it has all the possible guarantees of getting the full return on my investment plus high returns.

At this point, I have 4,000€ in liquidity and a difference of 20€ between the current price of the stock and my super-price. Now the price difference between the current quotation (60€) and the super-price (40€) we have to divide in equal parts, and in the same way our capital in liquidity. Therefore we can divide our capital into 4 parts of 1000€ each and the 20€ difference into 4 parts of 5€ each and in this way we already have the levels in which we will invest additional 1000€ each time the quotation drops 5€ and we will have enough liquidity until he goes down to our super-price.

A rule for you to do well is not to average a price that is less than 8% difference between the initial purchase and the next purchase to average, that is, I will not buy the company at 60€ and at 59€ I will re-invest. Such a small difference between the different prices will not excel in the returns of this long term. In the example I have explained the difference is greater than 8%, so it compensates for the risk with the possible long-term reward.

If instead of having bought 6.000€ initially we had bought less, 3.000€ for example, we would have 7000€ in liquidity to average, we would again divide the difference between the current price and the super-price and divide it into 3, 4, 5 equal parts (to the taste of the investor) and buy when it comes at the price we agreed. This is the standard way of averaging.

We can also increase or decrease the risk by doing the average in different ways…

– Increase the risk: Instead of dividing our capital into 4 equal parts I will give more money to the latest purchases, for example: Instead of buying 1,000€ each time I lower 5€ the quotation, the first 5€ I lower (the quotation would be 55€) I will buy 500€ only (I have left in liquidity 3,500€, the second purchase at 50€ I buy for 800€, the third for 1200€, and the fourth and last for 1500€.

– Reduce the risk: Exactly like the previous point but in this case, the first purchase to average is the most money we invest, and the last one the least, we would invest 1500€ first when the quote reaches 55€, 1200€ when it reaches 50€, 800€ when it reaches 45€, and finally 500€ when it reaches 40€.

By reducing the risk, I am not referring to the operation in general, but to the strategy of averaging downwards. Another day we will talk about selling a part of the portfolio to reduce the risk of the transaction in general.

-It is different from the average if we invest 6.000€ in the first purchase than 4.000€, the more money you invest in a certain price, the more the average cost will approach this.

– We can use the 3 ways of averaging, we just have to know what our profile is and if we will find ourselves doing this high-risk strategy.

– Never weigh at prices below 8% distance between several purchases. The risk does not compensate for the reward.

– It is not the same as a super-price for our example of 40€ that 59€, here it is clear that I will not average, it is not higher than the minimum 8%.

– In companies it is very risky, I would not advise you, you must be almost professional to do it in companies. In indices, it is different, although not all indices, choose one with large companies, and enough, SP500, Eurostoxx300, the VT would be perfect, etc. An idea to know a super-price of an index is to see the return for a dividend that gives and with which you would agree.

This is all, a risky strategy, but using it with a lot of heads and a lot of care can give us joy. As a last remark I repeat that I do not advise this technique in companies and in indices if you do not know how to use it well, it is very dangerous, but now you’re a little more knowledgeable about how to do it and avoid serious mistakes by buying too soon or in an underlying evil.

Averaging down or down-averaging is a term that describes the process of buying additional amounts of shares of an asset or financial instrument (such as Forex or commodities) at prices lower than the original purchase price. This reduces the average price paid by the investor for all of their purchased assets. Therefore, it is a strategy used to reduce the average cost in a market that has fallen in price. Is averaging down a good strategy or just another way to lose money in the market?

The answer depends on several factors. First, let’s describe how it works. You buy 10,000 shares at $100 per share, but these shares fall to $92 per share. You then buy another 1000 shares at $92 per share, which reduces his average price to $96 per share. It is true that this is a simplistic example, but we will describe the concept in more detail later.

Although it may seem to make sense, and actually sometimes works, it presents a great deal of risk. The price has to go up after the averaging is done. How many times have we acquired a stock that started to go down, invested more money after it went down, and continued to put more and more money in with the hope that the price will go up? Eventually, the point comes when we surrender and throw in the towel, shortly before the stock starts to recover. This is a very common scenario and it causes the ruin of many traders.

Description of Averaging Down Strategy

Although averaging downwards offers the appearance of a strategy, it is more a state of mind than a legitimate investment strategy. In theory, if an investor likes a stock at $35 per share, and the share price drops, but the investor still finds the stock attractive at 35, then buying more shares at a lower price offers the appearance of a discount. While there may be an unrecognized intrinsic value, buying additional shares simply to reduce the average investment cost is not a good reason to buy a share or other asset in the market as its price drops.

Averaging down allows investors to reduce their cost base in a given market position, which can work well if the market starts to rise as it allows the operator to acquire more assets at a lower price and increase its future profits. However, if the market continues to fall, capital losses will only increase further. Proponents of this technique see averaging down as a cost-effective approach to wealth accumulation; opponents see it as a recipe for disaster. In leveraged products like Forex and CFD, this practice can lead to large losses in a short time.

The strategy is often favoured by investors who have a long-term investment horizon and a counter-investment approach, that is to say, contrary to market consensus. An opposite approach refers to an investment style that is against, or contrary to, the prevailing investment trend. Here again, averaging can be a general rule: buy when there’s blood on the streets.

Interestingly, over the years, some of the world’s smartest investors, including Warren Buffett, have successfully used the averaging down strategy over the years. What also gives the illusion that this technique is an investment strategy. However, investors like Buffet can buy additional shares of a company because they feel that the shares are undervalued, not because they want to «lower the average». In addition, they have large capital resources that allow them to withstand a market downturn lasting months or years.

Is that a great strategy or not? If we average in a market that’s down and suddenly the price starts to rise strongly, then we’ll say what we did was a great strategy. However, if the market continues to fall, we must make the decision to keep averaging down or close positions to limit losses. At this point, much depends on the analysis of the market in which we are operating. If we are applying averaging down to fight price stubbornly in a market whose fundamentals clearly indicate that it will continue to fall, it is simply a gamble and a sure recipe to disaster.

On the contrary, if we have conducted a thorough analysis of the market and this study tells us that there is a likelihood that the price will start to rise, the downward averaging may make sense as long as we apply it sensibly following monetary management rules. In any case, we must always have a limit of losses as the market can be unpredictable and it is always good to have a safety net.

Stock Example

To show the difference between applying averaging down without a solid foundation and using this strategy based on more logical analysis and methodology. Let’s use it as an example of the difference between investing in a stock and investing in the company behind the stock.

If we are investing in an action, taking into account only the action of the price, we look for signs of purchase and sale based on a series of indicators. The goal is to earn money in the short and medium-term and there is no real interest in the underlying company beyond how its action might be affected by the market, news, or economic changes.

In most cases, much is unknown about the underlying company to determine whether a price drop it’s temporary or we’re talking about a big problem. The best thing to do when investing in shares under this approach (as opposed to investing in a company) is to reduce losses by no more than 7%. When stocks fall to this point, positions are closed and new opportunities are expected.

Invest In a Company

If you are buying stocks from a company (as opposed to a share), the investor has carefully researched and knows what is happening within the company and its industry. You need to know if a drop in stock price is temporary or a sign of trouble.

If you really believe in the company, averaging down can make sense if you want to increase your holdings in the company. Accumulating more shares at a lower price makes sense if you plan to hold them for an extended period.

This is not a strategy that should be used lightly. If there is a large volume of sales against the company, the investor may want to ask if they know something he does not know. These investors, who are making massive sales, are almost certainly mutual funds and institutional investors. Swimming upstream can sometimes be profitable, but it can also cause an account to be lost in a short time.

Averaging Down in Other Markets

Any market this strategy should be employed very carefully or avoided altogether if the trader does not know what it does, especially in leveraged markets like Forex or CFDs where profits and losses are magnified. In fact, this is how many traders lose their accounts. They continue to buy in heavily bearish markets in the hope that the price will rise to the extent that the losses that have accumulated are such that the inevitable ‘margin call’ arrives.

Many traders, especially beginners, have the tendency to «fight» against the market and when it starts to move against, do not bother to investigate because the market behaves in this way and simply start to open up positions contrary to the trend. In a market like Forex, where trends can be very strong, these traders end up losing big sums in a short time.

For example, a change in the interest rate policies of a major central bank such as the Fed or the BoE, are capable of shaking the market strongly and changing long-term trends. A trader who stubbornly trades against these moves and continues to add positions is only committing suicide.

Very different is when a trader adds more positions in a market whose fundamentals favor him and where the price is against him temporarily, more for technical factors than anything else. For example, it may happen that a currency pair is in bullish trend and the trader bought during a bearish correction that spread more than expected. In this case, the trader can average, to a certain extent, since he knows that the price has high chances of going back up. As we see, much depends on how the trader applies the strategy.

Who Should Apply Averaging Down?

The following table shows which types of investors can apply the averaging, and how to reduce the risk in case the market continues to fall. Here are some definitions of the main types of strategies.

Buy and Hold: It is a strategy where a person or company invests in an asset, such as an action, often for years. They are not interested in speculating on the purchased assets and their short-term movements, as they expect them to have an increase in long-term value that they can take advantage of.

Position Trading: A position trader is willing to invest in a market for months and even years until the signs of a major change in trend become evident.

Swing Trading: Swing trading operators try to take advantage of the trend movements of the market by trying to enter near the trend lows or trend highs, to win with the bullish and bearish price swings of the short and medium-term. The period in which operations are kept open is short, often for weeks or months.

Day Trading: A day trading operator conducts short-term trades where each position is usually closed before the end of the trading day.

Trading style, is it convenient to use averaging down?

Buy and Hold

Yeah, but be careful in a bullish market. Check your investments to make sure the fundamentals are still in good shape and that the technical aspects are attractive. Fibonacci setbacks work well in these circumstances. Measure the previous price increase from the minimum to the maximum of the movement and if you want to apply averaging down make the additional purchase around the Fibonacci retracement of 61.8% of the previous bullish movement. In a bearish market, then it’s best to wait. Otherwise, it’s like catching a falling knife. It can be a pretty dangerous process. Why risk it? Wait for markets to appear.

Position Trading

Yes, but it must hold the positions long enough for the market to recover and it must only be used in a market with the right conditions, that is to say in a bullish market. Ensure that the sector is also growing and that the fundamentals favour it so that any downturn in the market is due to short-term factors (as in the case of a stock with a bad quarter in a company with promising projections for the next quarter).

Swing Trading

Probably not. If we go in too early, expecting a change in trend and the price continues to fall, we can average down if the market and the industry are going up, but we do this only once. If we are tempted to average a second time, it is best to close the losing position and accept the loss. Remember, you are supposed to be a professional. Admit your mistake, take the loss, and continue.

Day Trading

No. As a day trading trader, the trader must leave before the end of the day and we have no guarantee that the price will be recovered at closing. A day trading operation should never be allowed to become a multi-day position. It is common for a trader to quickly lose their funds that way.