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.
Open a
demat account with
Indira Securities to begin trading today!