How the Average down technique works:
Let say you had purchased 500 shares of XYZ at $10/share and the price of XYZ dropped down to $8/share. You buy an additional 500 shares at $8/share to lower your average cost for the 1000 shares at $9/share.
500 * $10 = 5000
500 * $8 = 4000
1000 \ 9000 = $9
Risk of Averaging down
When you Average down on a descending stock you could be doubling your risk exposure on a bad bet. Unless the company has a turnaround, you could end up losing more than your original investment.
Benefits of Averaging Down
The benefit of averaging down is that if the stock price goes back up, it doesn’t have to go as far for you to turn a profit. With the example on top instead of having to go over $10 to turn a profit, the price only has get over $9 to make a profit.
To Average down or not to Average Down?
Whether to average down or not to average down should be calculated with your original plan and/or thorough due diligence; Are you investing long term or is this a swing trade? If this is a long term investment, then you have many big investors that believe in the Average Down approach, If this is a swing trade then most people will tell you to cut your loses and find another stock to purchase.
There are many times that there is a “bump in the road” and you get an opportunity to purchase the stock at a lower price, allowing you to make more profits in the trade. But before you double down you need to thoroughly think through your position size, do some due diligence as to what might have caused the stock to drop in price, and make sure you are not over exposing your risk.
If you’re down on a stock, and continue averaging down without a solid reason to, you’re probably investing emotionally, which is a big no no.
A recent good example of a profitable average down
Stock had good earnings report having increased profits by over 33%, but announced they would discontinue selling a loosing product in the US. The stock price dropped about 70% to $.51 where I purchased shares. The next day it dropped further to .40 creating a floor. The company has $.61 cash per share, and $.88 book per share and I felt it was deeply oversold due to it’s cash position and earning report. I purchased additional shares at $.41, and the next day the stock rallied to close at $.51, putting me into a profit.
A recent bad example of a bad time to average down
A company did an offering and reverse split, and the stock price dropped from $7 to $4 (I stopped out of the stock and did not average down). The stock continued to slide further down on a daily basis without ever recovering. 3 months later the stock did another offering and further decreased the stock price to $.38. From $4 to $.39, if anyone would have averaged down, they would have doubled their losses.