Averaging Down Trading Strategy (Statistics, Facts, & Historical Backtest)
If you trade stocks or any other financial market, you will often be confronted with that temptation: to buy more when the price goes lower. On the one part, you may have a cheaper entry price, but on the other hand, you may actually be doubling down on a losing trade. How do you approach the averaging down trading strategy?
Averaging down is a trading or investing method in which a stock owner buys more shares of a previously bought stock after the price has fallen. The main idea behind the average down technique is that it lowers the average purchase price, so when prices rise, it doesn’t take as much of an increase for the investor to start realizing a return on their investment.
In this post, we look at the averaging down trading strategy. We finish the article with a backtest.
Related reading:- A library of quantitative trading strategies
What does the averaging down trading strategy mean?
Averaging down is a trading or investing method in which a stock owner buys more shares of a previously bought stock after the price has fallen. The average price at which the trader bought the stock decreased due to this second purchase. It could be compared to averaging upward, where a trader buys more as the price rises.
Averaging down is so named because the average cost of the stock has been reduced. As a result, the point at which a trade can become profitable has been reduced.
The central concept behind the average down technique is that when prices rise, it doesn’t take as much of an increase for the investor to realize a return on their investment.
For instance, consider this: if an investor buys 100 shares of stock at $45 per share and the stock plummeted to $30 per share in price, the investor must wait for the stock to recover from a 33% reduction in price. However, based on the current price of $30, it will not take a 33% increase to return to break even. Now, a 50% increase in the stock is required for the position to return to the purchase price (from 30 to 45).
This mathematical truth can be addressed by averaging down. If the investor buys another 100 shares of stock at $30 each, the position will become profitable if the price rises to $37.50 (just a 25% increase). If the stock returns to its original price and continues to rise, the investor will begin to see about 16% profit by the time the stock reaches $45.
But it is not always that straightforward. The stock price can keep trading lower after further purchases. Nonetheless, as a part of a robust scale-in entry strategy, it can be a part of a smart investing plan. Some financial experts advise investors to use dollar-cost averaging (DCA) or average down with stocks or ETFs they plan to buy and hold.
Is averaging down a good idea?
Well, it depends on the situation. There are two parts to whether or not to buy more shares of a stock that is declining in value. On the one hand, when prices are substantially lower, you can add more to a strong position. On the other hand, you can be adding to a losing position if the price continues to dip.
So, averaging down can be a smart move depending on the circumstances. If the stock price rises, you will have effectively increased your trade’s profitability by reducing your average entry price.
But if there is a high volume of selling against a company, you would be going against the trend. Adopting a contrarian approach and buying shares when others are selling can be profitable at times, but it can also mean that you’re missing out on the risks causing others to sell. If the stock’s value later declines, the loss from the initial trade has grown much more.
This is why traders disagree on the issue of whether averaging down is a good technique. While average down provides certain features of a strategy, it is not a comprehensive one.
Actually, averaging down is more of a mental attitude than a wise investing plan — it enables a trader to overcome various mental or emotional biases. In this case, it serves more as a safety net than as a wise course of action. However, if used as a part of an entry strategy, in which case you are averaging down while scaling in to an already planned position size, it can be a good idea.
Is averaging a good strategy in trading?
It depends on whether you are a short-term trader or a long-term investor:
If you plan to invest in a company for the long term, rather than just trad