What is Averaging?

One of the acclaimed investing principles is "buy low and sell high". How much ever you try to stick to this principle, the stock market volatility makes it challenging for you. But, thankfully there is a way to deal with the sharp ups and downs in the stock market and that is AVERAGING.

Do you want to learn what is averaging in the stock market and how you can benefit from it? Then read on to find out!

What is Averaging in stock market ?

Averaging is a trading strategy that involves reducing or increasing your share prices to overcome market volatility. There are several ways by which one can average prices. These include average up, average down, and pyramid strategy. You can choose any of these averaging strategies depending on the market conditions.

Averaging works in both rising and falling markets. Let us understand how!

In the bull market, averaging reduces the cost of purchase of newly acquired units whereas, in the bear market, averaging reduces the loss as the average purchase price falls.

How to Use Averaging to your Benefit?

As mentioned earlier, you can use averaging to your advantage in both rising as well as falling market. If you buy stocks in the rising market, averaging can help you accumulate more profits. Likewise, if you buy stocks in the falling market, averaging can help you in reducing the average purchase price.

Traders and investors primarily use averaging in the hope of reducing their average cost of purchasing the stock.

Types of Averaging Strategies

Various averaging strategies employed by traders and investors in the stock market are:

·         Averaging Down

Averaging down involves buying more shares of a particular stock when its price goes down, which lowers the average cost per share. Here, a position is taken when the price comes below the original purchase price of the trader. 

For example, you purchase 100 shares at Rs. 300 (for Rs. 30,000).  Now, let’s say if the stock price falls to Rs. 200, you lose Rs. 100 per share. At this point, you have two options – you can either wait for the stock price to bounce back or buy additional shares at the lower price. The latter option will bring down your average holding cost. Let’s say, you choose the 2nd option of averaging down and buy 150 additional shares at Rs. 200. This will bring down the average holding cost to Rs. 240 (Rs. 60,000/250 shares).

With averaging, your holding is now closer to the current market price and even with a short bounce in the share price, your position can turn profitable.

·         Averaging Up

Averaging up involves buying more shares of a particular stock when its price goes up, which increases the average cost per share. Although averaging up increases the average cost per share, if you buy into an up-trend, it can significantly amplify your returns.

The strategy works well when the investor believes that the stock price will further rise thus taking advantage of momentum in a rising market.

For example, you purchase 100 shares at Rs. 300 intending to sell them when the price touches Rs. 350. Now you are convinced that the market will remain bullish so you keep adding further 100 shares at the interval of Rs 10. So, when the price touches Rs. 310, you purchase another 100 shares and so on. That way, you now have 500 shares bought at Rs. 300, Rs. 310, Rs. 320, Rs. 330 and Rs. 340 with an average price of Rs. 320. 

By averaging up, you now have 500 shares in your portfolio at an average price that is still lower than the current market price. Hence, averaging up can be very profitable when used in a bull market.

·         Pyramiding

Pyramiding is a type of averaging up strategy where the trader keeps buying the stock at multiple price points. Here, the trader adds to his position based on the assessment of technical indicators such as chart pattern breakouts, penetration of resistance levels, moving average breakouts and other technical analysis.

Conclusion

You can choose any type of averaging strategy depending on your investment decision. However, it is wise to use it in fundamentally strong stocks or blue-chip companies to reap maximum benefits. You can carry out a fundamental check on the company’s balance sheet strength, management quality, core proposition and valuation to make a decision. Because even when the market is crashing, holding a position in a strong company always has a good chance of recovering.

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