Averaging Down and Pyramiding Up

Q. What does 'averaging down' mean?


A: Averaging down is buying stock when the price lowers so that your overall holding is priced lower than your initial investment. Unfortunately, many spread betting traders make the mistake of letting losses run or even doubling up on their losing trades.

For example:-

First of the month you buy 5000 shares of ABC Plc at 200p which equates to £10k.

On the 20th of the month the price has gone down to 180p and you buy 5000 shares which equates to £9000.

Overall you now have 10,000 shares at a price of £19k which equates to an average of 190p per share as opposed to 200p per share as per your first trench of shares.

You should only average down if you know a share will pick up, this requires you to be familiar with the company's fundamentals, and also be certain that the company in question is in your mind the best prospect in the over 3,000 other stocks listed. If this is not the case you should probably not have invested your initial stake in the first place! In retrospect I would say that averaging down is often a mugs game. As Vince always says let the trend be your friend, that is oh so true...

"The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximize the suffering, and also to ensure that as few as possible escaped the common misfortune."

Q. You mention that you may average a long trade if it's going against you but not a short one? Why?

A: About averaging long but not short is based on the fact that there is no ceiling 'long' but there is very clearly a 'bottom' short. In other words a stock can go up over 100%, but can't fall more than 100%. So if you go long on something that is $100, then you know how much you will lose if it went to $0 even if you averaged down. But if you went short, then you would never know how high the price may go as the sky is the limit. So averaging down on long positions is much safer than doing it on short positions.

You can average any trade you want either up or down. However, I wouldn't recommend it if you are a beginner as if you are wrong then you will simply compound your losses. So care needs to be taken here - only average if you have experience!

I would also say that averaging up or down depends on the reason you took the position in the first place. If you bought an oversold market, it goes down and is even more oversold that might be a good reason (maybe to average down). If you bought a rising trend and it dips below key support, it would be a bad idea to average down; you would be more prudent to cut losses and (maybe) go short instead.

Pyramiding up, (when the trade goes correct) on the other hand is a sensible strategy which at the worst would cap your profits as opposed to increasing your losses.

Comment by Joe: 'I fully agree with that, I'm inexperienced at this, one very harsh lesson learned was when a trade went wrong once (and I convinced myself that I had just got in at the wrong time) so I kept averaging. The losses were quite frankly shocking - but it was a very valuable lesson in cutting losses early, preserving capital for another trade.'

 ...Continues here - Leverage and the Dangers of Overgearing

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