Averaging down is adding to a position as the trade loses money. The logic is that buying at lower prices reduces the cost of the position. This increases the gain if the price goes back up, or gets the trader back to breakeven quicker.
Averaging down can result in large losses if a trader keeps buying while the price keeps dropping. But there are times it can be beneficial, such as when it is planned out in advance.
Averaging down isn’t always bad, nor is it always good. In this article, we’ll look at when it is worth doing, and when to avoid it.
Averaging down is also called dollar-cost averaging, a term typically reserved for a long-term investment strategy.
Examples of Averaging Down
Assume you buy a stock at $100. Instead of going up, it does down.
At $90, you still believe the stock will go up, so you buy more. Alas, it drops more.
At $80 it seems like a real bargain. You buy more.
That is averaging down. As the price drops, the position is increased.
Assume you bought 100 shares on each trade. After the first trade, the average price is $100. After the second purchase, the average price is $95 (($100 + $90) / 2). After the third purchase, the average price is $90 (($100 + $90 +$80) / 3).
The lower average price is the allure of averaging down. The first purchase at $100 is $20/share in the negative when the price hits $80. But by averaging down, the total position is only down $10/share (stock at $80, average position price is $90). If the price moves back above the average price of $90 the trader is now making money. Without averaging down, the price needs to move back above $100 before the trade makes money.
The problem is that they are now losing money on a 300-share position instead of the originally planned 100-share position. Essentially, to lower the average price means taking on more risk and potentially a larger loss.
Averaging down can also occur on a short position.
Assume you short a stock at $50 thinking it is bound to drop.
The price rises instead. You still think the stock is crap and so you short more at $56.
The price keeps going up, because of “Stupid buyers who don’t know anything!”, and so you short more at $60.
Calculating Average Price When Averaging Down
If all the purchases are for the same number of shares, then just add up the purchases prices and divide by how many purchases there are, like we did above.
For example: 100 shares are purchases at $50, $40, and $30. The average price is:
($50 + $40 + $30) / 3 = $40
If each trade has a different number of shares, then we use a different formula.
Assume someone purchased:
65 shares at $50
55 shares at $40
70 shares at $30
How many shares it is doesn’t matter; the process discussed below is the same.
Add up the total number of shares: 65 + 55 + 70 = 190 shares
Now figure out the average cost of the whole position by dividing the number of shares purchased at each price by the total number of shares, multiplied by the respective purchase prices:
(65/190) x $50 = $17.11
(55/190) x $40 = $11.58
(70/190) x $30 = $11.05
We go through this process so that each price we buy at is weighted based on the number of shares purchased.
Is Averaging Down a Good Idea?
In the scenarios above, if the price keeps going against the trader, it can be a disaster. Especially if they put a lot of their capital on the line, or worse yet borrowed money (leverage) to add to their position. Often the pain of the loss becomes too great and the trade is exited with a big loss. If trading on leverage, it’s possible the broker will close the position as the trader’s capital evaporates.
A lower average price doesn’t mean anything if the price keeps dropping on a long position. No matter how you slice it, the loss is getting bigger.
Averaging down can also lead to “get-even-itis” an affliction where a trader takes on massive risk by averaging down, only to exit the trade if they can get out near flat. This is the opposite of what pro traders do.
Pro traders risk very little to make a lot; amateur traders risk a lot and then are happy to make a little or not lose. This is called risk/reward, and is a key factor in profitable trading. Over many trades, it is hard to be profitable with the amateur approach (big risk, low reward).
Position sizing could also be an issue. When most people take a trade, they put in the amount of capital they want to. If they have a $50,000, maybe they decide to put $10,000 into the trade. But as it starts dropping they buy another $5K or $10K, and then maybe another $5K or $10K when it drops more.
Now they’re into this trade for $30K when they only originally wanted to put $10K into it. They probably didn’t want to a lose much of the$10K, and now they’re losing A LOT on $30K. Definitely not what was planned. That’s a problem. They have totally deviated from what they were planning to do.
If they were supposed to place a stop loss, and get out with a small loss if the trade went against them, then that plan has also been violated. Not only did they not get out, they increased the position which increases the size of the loss if the price keeps going against them.
Deciding spur of the moment to average down is not usually a good idea. Averaging down is often driven by a desire to NOT take/realize a mounting loss. Averaging down increases the risk of the trade, but it also reduces the average price (if you’re buying) of the position. So if the price does rise, you get back to breakeven or a potential profit quicker.
The reduction in average price can be alluring. If the price starts moving favorable, the trader can get back to breakeven or even make a big profit if they hold on. But, a big risk has been taken to make that possible profit.
Pro traders risk a small amount of their capital to see if something works. If the trade does work, they ride it for a bigger gain than what they risked. Pro traders understand that they don’t and can’t know what will happen in the future. There are no guaranteed winning trades. Any trade can lose, and any company/stock can have price movement that we don’t understand.
There’s no guarantee that averaging down will work. But if done many times, there’s a high probability of massive loss.
Generally, don’t average down. But there are two exceptions:
- Pre-planned scaling into a position.
- Making regular contributions to an index-related buy-and-hold investment such as a low-cost ETF with a long history of upward price appreciation.
My Complete Method Stock Swing Trading Course guides you through the process of stocks that are likely to rally 20% or more over the next few weeks. One entry point with a stop loss and target. No scaling or averaging.
Scaling In Versus Averaging Down
There is a difference between averaging down and scaling in.
The difference is planning.
Most people who average down are doing so to avoid a loss. The averaging down wasn’t planned and thus results in a larger position than originally planned.
Scaling into a position is done when we don’t know the best entry point. We decide how much capital we want to allocate to the trade and then we scale in, buying a portion of our desired position at different prices.
Maybe our analysis shows that a stock is starting to turn higher. We decide to break up the capital we have allocated to this trade into 3 or 4 entries instead of 1. Maybe we buy a bit when we see the first sign that the stock is turning around. If it keeps dropping we buy a bit more at the next turnaround signal. If the price starts rising, we buy a bit more. We buy the rest of the position on another trade signal.
This could be averaging down in that we may be adding to position as it drops. But is pre-meditated and the position size is only as big as planned. In this way, the risk is known and acceptable (otherwise don’t take the trade).
This approach can be useful for initiating positions in stocks that we like the long-term prospects of, such as those on the Buy the Dips Stock List. When they decline, we have a chance to get a good price, but we may not know exactly where to buy. Scaling in makes sense.
An Alternative to Averaging Down
Instead of averaging down, or even scaling in, a popular option is to choose an entry point and then place a stop loss to exit the trade at a small loss if the price doesn’t move as excepted.
With this approach, multiple small losses may be taken before a trade works out, but there’s very little risk of ever experiencing a large loss.
This topic goes back to risk/reward. If over many trades the wins are bigger than the losses, and the losses are kept small, then even with only winning 30% or 40% of trades (or more) it is possible to be profitable.
This approach is common in day trading and swing trading. The trader enters at a point where they expect the price to start moving in a particular direction (such as a triangle/contraction pattern). They place a stop loss in case the stock moves the wrong way, and they have an exit strategy such as a profit target or trailing stop loss strategy for taking profit if the trade does move favorably.
Averaging Down and Investing
Averaging down can be advantageous in long-term investing. Although, since the buying is pre-planned, I would consider this scaling in, not averaging down.
In my Passive Stock Investing Using ETFs eBook I layout which ETFs to regularly invest in. That means making regular contributions whether the price is going up or down. This is because for the last 150 years the stock market has risen, averaging more than 9% per year (US stock index).
With a long-term upward bias, making regular contributions makes sense. We don’t know how far the price will drop or rise, but we do know that over long periods of time there is an upward bias. Regular contributions take advantage of that.
Once again, this is part of a strategy and is pre-planned. The amount of capital going to the position each month (or whenever) is pre-planned and is part of a long-term investment strategy.
Averaging Down and Day Trading
I see no reason to average down when day trading.
For day trades, we need to be in and out quickly. Adding to a losing position, when unplanned, means wasting valuable time and losing money, when we could use that time to make money elsewhere. Cut losses quickly and move on to the next opportunity.
When day trading, we have a limited time window for a trade to bounce back in our favor. That may not happen if we average down, which means exiting with a loss and wasting our trading time.
I like entering and then setting a stop loss and target. If the trade doesn’t work, cut it quickly and find something else.
Here are several examples. All these entry methods are discussed in the EURUSD Day Trading Course mentioned below.
The red area shows the amount risked on the trade. The green area shows the profit. This day could have resulted in a 7.5% gain over three trades, keeping risk controlled and exiting at a bigger profit than what was risked (2.5:1 in this case).
That said, scaling in and out of the position is possible.
Scaling in and out of the position is useful for those who want to accumulate a position at different prices, instead of a single price. This may be necessary if trading a large position size (relative to the volume that’s available at the bid/ask price). The overall position size is still controlled, and so is the risk.
My EURUSD Day Trading Course guides you through trading a few common patterns that tend to occur multiple times per day, providing loads of opportunities to capitalize.
Averaging Down and Swing Trading
Avoid averaging down when swing trading.
Scaling into and out of positions is ok because the position size and risk are still being managed in a methodical way.
I prefer taking one entry on my swing trades. I take a trade, and if it doesn’t move as expected I get out having lost only a small percentage of my capital and I look for another trade.
I like to keep my risk per trade near 1% of my capital. That doesn’t mean I only put 1% of my capital into a trade; it means I get out if I’m losing 1% of my total capital. See 1% Risk Rule for more on how that works.
It ends up looking something like this. My strategy tells me when to enter, which in this case is when the price moves above a consolidation within a contraction pattern. I set a stop loss below the consolidation (red area) and set a profit target based on how far the stock tends to run (green area). This trade produced a 31% gain, and that profit was about 5.6 times greater than the risk taken.
All the elements of this strategy are covered in the Complete Method Stock Swing Trading Course.
Averaging Down as Part of a Trading Plan
Scaling in is ok. Risk is still controlled and the process is pre-planned. Before doing it, plan out why you want to scale in and how you will do it. How will you manage your risk while doing it? What are the entry signals for accumulating the position?
If you are investing in index ETFs, when you will make regular contributions?
A trading plan is a document that outlines our strategy for trading or investing. At minimum, it lays out how we will enter and exit positions and manage risk. The strategy is based on research we conduct or someone else’s strategy that we’re opting to use.
Averaging down is not generally a good idea. Doing so is usually the result of violating some of our trading rules, such as too large of a position size, taking unplanned trades (additional entries we hadn’t pre-planned), ignoring sell rules, trading with a poor a reward:risk ratio, or risking too much, for example.
How is Pryamiding different than Averaging Down?
Pyramiding is adding to a position as it moves favorably. Averaging down is adding to a position as it moves unfavorably. Few successful traders average down, but many successful traders pyramid. As the trade shows a profit, they add to the position, often moving the stop loss as well so that risk of the trade gets smaller or stays the same even though the position size has increased. Most traders add less and less the further the price goes. For example, they may buy 100 shares initially, then add 50 shares if the price moves favorably, then 25 more shares if it keeps going.
By Cory Mitchell, CMT
Disclaimer: Nothing in this article is personal investment advice, or advice to buy or sell anything. Trading is risky and can result in substantial losses, even more than deposited if using leverage.