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Averaging Down definition

Averaging down is an investing strategy where a stock owner or trader buys additional shares of an asset he had previously invested once its price has gone down to decrease the average price of his or her investment. As a result, the point at which a trade can become profitable is lowered because the average cost of the asset has also been lowered.

To illustrate how averaging down works, take for example you bought 100 shares of a stock at $50 per share for a total of $5000. Once the price of the stock goes down to $40 per share, you decide to purchase an additional 100 shares for a total of $4000. The result is you brought down the average price of your investment to $45 per share, which is computed at ($5000 + $4000)/200 shares = $45 per share. This means you’ve lowered the original cost per share by $5 ($50 – $45 = $5). 

What You Need to Know About Averaging Down

The most typical scenario where averaging down is applied is when a stock that a trader owns declines in value. He or she could sell and accept the loss, do nothing and hope that the price would increase again, or average down, which is to buy additional shares while the price is low, and wait until the value climbs up again.

While this strategy can pay off if those shares eventually rise in value, it’s not as simple as that and as with everything else in trading, there are risks involved.

Some experts advise against using the averaging down strategy, while others remind traders to be cautious when adding it to their trading plan. This is because averaging down can result in an even greater loss than when you started if you do not know what you are doing or have no idea how it could impact your position.

Averaging down is oftentimes compared to how a dollar-cost averaging works. By using dollar-cost averaging in your investment, you continuously put money into your investment regularly, regardless if the stock prices had gone up or down. The rationale behind this is that by investing continuously, your returns will be more in the long run or even out at the very least.

The opposite of averaging down is averaging up, which is essentially buying more shares of stocks as their price increases.

The Benefits of Averaging Down

The primary benefit of averaging down is the potential of significant gains when you can take advantage of the market by buying low and selling high. This means you were able to buy the dip and sell what you bought at a higher price to earn a nice profit. 

However, this strategy requires knowledge on the part of the trader on how market cycles work so that he or she can distinguish when a stock is experiencing a short-term or temporary downturn or when it is stuck on a downward trend with a steady pattern of decline prices.

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