Averaging up and down

Averaging up or down refers to a technique where investors purchase additional shares of an already existing position after the price has changed.

By doing so, if the price of the security has dropped, investors lower the average cost paid for the overall position with the expectation that the price will eventually rise, so they can profit.

If the price of the security rises, this will increase the average cost paid.

Let’s check out an example:

Suppose you bought 100 shares of XYZ stock at $10 a share (for a total investment of $1,000). A month later, the stock price drops to $8 per share, but you decide to keep holding as you expect the price of the stock to increase in the future.

And now that the price is lower, you go ahead and buy 100 additional XYZ shares at $8 per share (for a total investment of $800). Now, you have 200 XYZ shares with average price of $9 [$1800 (amount invested) / 200 (# of shares) = $9).

Three months later, XYZ stock is trading at $15 per share and you decide to sell. By averaging down you would earn $1200 profit [$3000 (selling price) - $1800 (price paid)] vs. if you had not averaged down your profit would stand at $500 [$ 1500 (selling price) - $1000 (initial first investment)].

However if after averaging down, the share price continues falling, losses could be greater due to the fact that the investor owns more shares as a result of averaging down.