What is Averaging in Stock Market?

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One word that has generated more heat in the trading community is averaging. Many traders have lost their shirts trying to average on a losing position. At the same time, many professional traders owe their wealth generation to averaging on a winning position. 

In other words, averaging is a money management tool that can be both very effective as well as devastating, depending on who is holding it. 

Averaging, when it comes to trading, is different from that in investing. The main difference is time. To understand this more clearly, let’s look at the types of averaging and the approach taken by a trader and an investor.  

 

 

Averaging down

• It involves buying the same instrument when the price goes down
• Quantity of buying can remain same or change according to the traders/investors strategy
• Average holding price comes down
• The strategy works well in a rising market, when averaging down is done during corrections
• If taken during a downtrend, it can result in a huge loss or may take time before price comes back to the average price

In the case of averaging down a trader or an investor adds to the position when the price has come below his original purchase. 

Suppose a trader bought 100 shares at Rs 300. The purchase would cost him Rs 30,000. Now, for some reason, the stock falls by 5 percent and the trader decides to add more shares at this price. He will buy 100 more shares at Rs 285 for a cost of Rs 28,500. He is now holding 200 shares worth Rs 58,500, with an average price of Rs 292.5. 

The trader’s holding is now closer to the current market price and, in case of a short bounce in the share price, his position will turn profitable. 

On principle, this looks like a good strategy for adding a position, since stocks tend to move higher most of the time. More often than not, this way of adding position will pay off, but on those few occasions it does not, the damage will be colossal. 

A bear market is the worst time to try this strategy, as shares can keep on falling for a long time. As the famous economist, John Maynard Keynes said, ‘Markets can stay irrational longer than you can stay solvent.’  

The difference between a trader trying out an Averaging down strategy and an investor is time and capital. A trader normally has a leveraged position that cannot be held beyond a point. If he trades using options, he will have to come out of his position before the expiry of the contract. If he uses futures, he will have to keep on rolling his position and pay the margin shortfall as the share price keeps on falling. 

An investor is someone who holds on to a share for a longer time. He does not have a leveraged position and can patiently build his position by adding small quantities as the price goes down. An investor averages his position in the cash market. 

Averaging Up

• Averaging up is done when prices move higher for a long trade
• In case of a short trade, new quantities are added when price moves lower
• The quantity added depends on the traders money management strategy
• Average price of the trade increases in a long trade with every new addition 
• Average price of the trade reduces in case of a short trade with every new addition

This strategy is normally used by professional traders and has been one of the main reasons behind their wealth creation. 

Unlike averaging down, where traders add to a losing position, in this money management strategy, a trader will add to his position only when it is profitable. 

Taking the initial example, suppose the trader bought 100 shares at Rs 300 intending to sell them when the price reaches 350. He will only add to his position if the price touches say Rs 310. He is now holding 200 shares at an average price of Rs 305. If he adds 100 shares at an interval of Rs 10, he would have 500 shares bought at 300, 310, 320, 330 and 340 with an average price of 320. 

These professional traders always have a stop loss and would be out of their position if the stock falls. Thus, with every new position, his risks is lower and he can ride the entire trend confidently. 

A type of Averaging Up strategy is called Pyramiding, where the trader adds to his position only when a technical indicator or a chart pattern he follows prompts him to. Again, the pyramiding style is commonly used by professional traders. 

Investors also add to a winning position and may link it to an event like a strong quarterly performance or an important announcement. 

A common type of averaging is seen in the mutual fund industry, where Systematic Investment Plans (SIP) are used to buy more units of the fund. This type of averaging is not price-based but time-based where the investor buys units of the mutual fund scheme on the same date every month. This style of investing is called Rupee Cost Averaging. 

How to use averaging in the stock market’s cash segment

If one is an investor, he can either use averaging up or averaging down style, but the most important point is to use it in fundamentally strong stocks or blue-chip companies. This way, even if the stock falls sharply, the investor will at least be holding a strong company that has a good chance of recovering.