Averaging down definition

What is averaging down?

Averaging down is when a market participant buys more of a stock they already own after the price has declined. In doing so, they will reduce the average price at which they purchased the stock and could stand to realise a greater profit if the market value recovers above the new average price.

How does an averaging down strategy work?

An averaging down strategy works by reducing the average price that shares were bought at, by purchasing additional shares at a reduced. As a result, the underlying market price doesn’t need to rise as much in order for the position to generate a profit.

The calculation to determine the average is:

For example, let’s suppose that an investor initially paid £110 per share. If the price falls to £100 per share, the investor might choose to buy the same number of shares they initially did in order to average down the price they paid per share to £105. This is achieved by (110 + 100) /2.

An averaging down strategy is most effective for investors and traders who believe that a company will perform well in the long term despite any immediate declines in the value of its stock. However, if the downward trend continues for a sustained period of time, they could find that they incur a greater loss than if they had not employed an averaging down strategy.

Averaging down vs averaging up

While averaging down is a strategy used by investors and traders who have an overall positive market outlook, averaging up is a strategy used by short-sellers with an overall pessimistic view of the markets.

In an averaging up strategy, a short-seller would sell additional shares as the price continues to rise with the view that one day, the price will crash. In doing so, the trader will increase the size of their short position in the hope that they will realise a greater profit if the stock starts to lose its value.