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Definition:
Averaging down (also known as cost averaging) is a type of strategy used by many day traders. The purpose is to lower your average cost in a stock that has lost value from the starting point at which you previously bought it at.
An Example:
An example to illustrate what averaging down is begins with a trader buying 200 shares of stock X at $22.00 per share. Instead of gaining in price, the stock then falls down to $21.50 per share. The trader then averages down by buying an additional 200 shares of stock X at this lower price of $21.50 per share which lowers his/her average share price to $21.75 per share. This price is below the original buy in price but above the latest purchasing price.
Criticisms:
Averaging down can cause you to overinvest in a stock that may be trending downwards. The investor may have chosen to do this for two reasons; the first being that they do not want to give up on their trade and are not exiting out of a losing position. This may be due to poor “psychological investing” on the part of the trader. Not exiting out of a losing position is one of the most common downfalls of beginning day traders and it can cause great losses in addition to losing liquid capital to trade with. In other words, not only might you lose money but you are also using up funds that you would have otherwise been able to invest in other strategic day trades.
If the stock continues to plunge in value and the investor has decided to average down due to emotional investing, he/she may very well continue to average down and buy into a rapidly decreasing stock in a losing game. In addition, the amount of shares of this one stock is rapidly increasing which reduces your ability to exit out quickly if necessary and also places a larger percent of your investment in one company (or.. “all your eggs in one basket”). This last part is called overexposure.
A Strategic and Well Thought Out Plan:
The second reason an investor may have decided to average down, is that they have a strategic plan in place based on their expert knowledge of the “rhythm” of their stock. Many stocks swing up and down by varying points throughout a trading day and having knowledge of that stocks average high’s and low’s can give the well-studied trader a guideline on how likely a stock is to continue to plummet or to return up and above your original buy in price. If the stock dropped but is still within its’ regular up and down rhythm for the day than an experienced trader may average down to increase their potential profits, since they know there is a higher likelihood of the stock trending back upwards towards its’ average.
Successful Strategy:
Averaging down can be a great tool for the well prepared trader, but is often not advised for traders who are not intimately familiar with their stocks daily fluctuation range. To use it successfully, make sure you know your stock’s regular up and down rhythms.. watch your stock daily and look at old pattern charts of your stocks. If during a trade you feel very anxious or fearful that you will lose your money, cut your losses and sell your shares early to ensure that you are trading objectively and not based on emotion. It is much better to take a small loss and get out of a play that you are not comfortable with than to stay overfocused and overinvested in one stock which is plummeting and tying up your capital for any other trading.
source-http://eliza-kay.hubpages.com
Averaging down (also known as cost averaging) is a type of strategy used by many day traders. The purpose is to lower your average cost in a stock that has lost value from the starting point at which you previously bought it at.
An Example:
An example to illustrate what averaging down is begins with a trader buying 200 shares of stock X at $22.00 per share. Instead of gaining in price, the stock then falls down to $21.50 per share. The trader then averages down by buying an additional 200 shares of stock X at this lower price of $21.50 per share which lowers his/her average share price to $21.75 per share. This price is below the original buy in price but above the latest purchasing price.
Criticisms:
Averaging down can cause you to overinvest in a stock that may be trending downwards. The investor may have chosen to do this for two reasons; the first being that they do not want to give up on their trade and are not exiting out of a losing position. This may be due to poor “psychological investing” on the part of the trader. Not exiting out of a losing position is one of the most common downfalls of beginning day traders and it can cause great losses in addition to losing liquid capital to trade with. In other words, not only might you lose money but you are also using up funds that you would have otherwise been able to invest in other strategic day trades.
If the stock continues to plunge in value and the investor has decided to average down due to emotional investing, he/she may very well continue to average down and buy into a rapidly decreasing stock in a losing game. In addition, the amount of shares of this one stock is rapidly increasing which reduces your ability to exit out quickly if necessary and also places a larger percent of your investment in one company (or.. “all your eggs in one basket”). This last part is called overexposure.
A Strategic and Well Thought Out Plan:
The second reason an investor may have decided to average down, is that they have a strategic plan in place based on their expert knowledge of the “rhythm” of their stock. Many stocks swing up and down by varying points throughout a trading day and having knowledge of that stocks average high’s and low’s can give the well-studied trader a guideline on how likely a stock is to continue to plummet or to return up and above your original buy in price. If the stock dropped but is still within its’ regular up and down rhythm for the day than an experienced trader may average down to increase their potential profits, since they know there is a higher likelihood of the stock trending back upwards towards its’ average.
Successful Strategy:
Averaging down can be a great tool for the well prepared trader, but is often not advised for traders who are not intimately familiar with their stocks daily fluctuation range. To use it successfully, make sure you know your stock’s regular up and down rhythms.. watch your stock daily and look at old pattern charts of your stocks. If during a trade you feel very anxious or fearful that you will lose your money, cut your losses and sell your shares early to ensure that you are trading objectively and not based on emotion. It is much better to take a small loss and get out of a play that you are not comfortable with than to stay overfocused and overinvested in one stock which is plummeting and tying up your capital for any other trading.
source-http://eliza-kay.hubpages.com
