Averaging Down Trading Strategy (Backtest)

Last Updated on November 21, 2022 by Oddmund Groette

If you trade stocks or any other financial market, you will often be confronted with that temptation: to buy more when the price goes lower. On the one part, you may have a cheaper entry price, but on the other hand, you may actually be doubling down on a losing trade. How do you approach the averaging down trading strategy?

Averaging down is a trading or investing method in which a stock owner buys more shares of a previously bought stock after the price has fallen. The main idea behind the average down technique is that it lowers the average purchase price, so when prices rise, it doesn’t take as much of an increase for the investor to start realizing a return on their investment.

In this post, we take a look at the averaging down trading strategy. We finish the article with a backtest.

What does the averaging down trading strategy mean?

Averaging down is a trading or investing method in which a stock owner buys more shares of a previously bought stock after the price has fallen. The average price at which the trader bought the stock decreased as a result of this second purchase. It could be compared to averaging upward, where a trader buys more as the price rises.

Averaging down is so named because the average cost of the stock has been reduced. As a result, the point at which a trade can become profitable has been reduced. The main concept behind the average down technique is that when prices rise, it doesn’t take as much of an increase for the investor to start realizing a return on their investment.

For instance, consider this: if an investor buys 100 shares of stock at $45 per share and the stock plummeted to $30 per share in price, the investor must wait for the stock to recover from a 33% reduction in price. However, based on the current price of $30, it will not take a 33% increase to return to break even. Now, a 50% increase in the stock is required for the position to return to the purchase price (from 30 to 45).

This mathematical truth can be addressed by averaging down. If the investor buys another 100 shares of stock at $30 each, the position will become profitable if the price rises to $37.50 (just a 25% increase). If the stock returns to its original price and continues to rise, the investor will begin to see about 16% profit by the time the stock reaches $45.

But it is not always that straightforward. The stock price can keep trading lower after further purchases. Nonetheless, as a part of a robust scale-in entry strategy, it can be a part of a smart investing plan. In fact, some financial experts advise investors to use dollar-cost averaging (DCA) or average down with stocks or ETFs they plan to buy and hold.

Is averaging down a good idea?

Well, it depends on the situation. There are two parts to the idea of whether or not to buy more shares of a stock that is declining in value. On the one hand, when prices are substantially lower, you can add more to a strong position. On the other hand, you can be adding to a losing position if the price continues to dip.

So, depending on the circumstances, averaging down can be a smart move. If the price of the stock rises, you would have effectively increased your trade’s profitability by reducing your average entry price. But if there is a high volume of selling against a company, you would be going against the trend. Adopting a contrarian approach and buying shares when others are selling can be profitable at times, but it can also mean that you’re missing out on the risks that are causing others to sell. If the stock’s value later declines, the loss from the initial trade has grown much more.

This is why traders disagree on the issue of whether averaging down is a good technique. While average down provides certain features of a strategy, it is not a comprehensive one. Actually, averaging down is more of a mental attitude than it is a wise investing plan — it enables a trader to overcome a variety of mental or emotional biases. In this case, it serves more as a safety net than as a wise course of action. However, if used as a part of an entry strategy, in which case you are averaging down while scaling-in to an already planned position size, it can be a good idea.

Is averaging a good strategy in trading?

It depends on whether you are a short-term trader or a long-term investor:

If you plan to invest in a company for the long term, rather than just a stock, you would have to know about the company. So, you may have a better sense of whether a drop in the stock price is temporary or a sign of trouble, based on the company’s past performance and current state.

In other words, averaging down may make sense if you truly believe in the company and want to increase your holdings. If you intend to hold the stock for a long time, buying more at a lower price makes sense. In this case, you use it as a part of an entry strategy. That is, you are averaging down while scaling in to an already planned position size at lower prices so that your average purchase price becomes lower.

On the other hand, averaging down is probably not the best method for you if your only objective in the trade is to earn money and you have no actual interest in the underlying company other than how market, news, or economic events can affect its price. The reason for this is that you don’t know enough about the underlying business to tell whether a price decline is transient or indicative of a significant issue. For short-term trading, it’s common practice to manage risk and limit losses after having lost a particular sum.

Is it better to average up or down in stocks?

It depends on your trading strategy and plan. Both averaging up and averaging down are used to scale into position, and scaling in is best suited for a long-term trading approach, even though short-term traders might attempt averaging up.

If you are a long-term trend follower, you can use either method, depending on what your analysis of the stock shows and your risk tolerance. A short-term trader can use averaging up to increase potential profit when their prediction is right. When averaging up, you are using your floating profit from the initial trade to enter a second position at a higher price, so the risk is reduced but not eliminated, as the price can still reverse and erode that floating profit and lead to a loss.

On the other hand, a long-term contrarian trader would favor average-down because the nature of their trade signal is that the signal gets juicier the farther away the price goes in the opposite direction.

Why should you not average down?

The issue with averaging down is that you may find it difficult to differentiate between a temporary price decline and the onset of a significant price drop. You don’t want to be in the way of a falling knife; it can hurt your trading account if you are a short-term trader.

Buying extra shares just to reduce the average cost of ownership may not be a solid rationale to raise the proportion of your portfolio exposed to the price action of that one stock, even though there may be unrealized intrinsic value in buying at a lower price. While some may see averaging down is viewed as a cost-effective strategy for accumulating wealth by proponents, it could be a surefire recipe for failure.

For instance, a stock trading at $50 per share declining to $40 is not a signal that it will turn from there and start rising. There is nothing that stops it from falling down to $20 or even $0. You don’t just buy more shares because the price has fallen lower unless it is a part of a well-planned entry strategy.

How do you average down to break even?

You don’t achieve breakeven by simply averaging down. Buying stocks at a lower price than you bought them initially does not automatically make you achieve breakeven. It only lowers your average purchase price. The stock would still need to rise for you to achieve breakeven. The only thing averaging down does is make the requireid rise needed to achieve breakeven lower.

For instance, assuming you bought 100 shares of a stock at $40 each. When the share price dropped to $20, you purchased an additional 100 shares. What you have done is reduce your average share price to $30. So, you are still $10 below the price you paid when you first purchased the stock.

To put it differently, even though your average purchase price decreased, you are still losing money on your initial purchase because a $20 decline on 100 shares equals a $2,000 loss. So, do not mistakenly believe that buying additional shares to average down the price will miraculously reduce your loss. You only recover the loss when the price moves from $20 to at least $30.

Averaging down formula

To calculate the breakeven price when averaging down, you can use this simple formula:

[(N1 of shares x purchase price) + (N2 of shares x second purchase price)] / (N1 + N2) of shares

Where:

  • N1 = initial number of shares purchased
  • N2 = number of shares at the second purchase

In other words, you divide the total amount spent in buying the shares by the total number of shares bought on the occasions to arrive at the breakeven price. But this does not take into consideration the trading fees (spreads and commissions).

Averaging down calculator

There are many stock trading tools online that you can use to track your average down strategy. They can calculate the average cost of your stocks when you purchase the same stock multiple times. They will give you the average cost for average down or average up.

Averaging down example

Let’s say you buy 100 shares of XYZ at $45.00 per share and the stock plummeted to $30.00 per share in price. If you buy another 100 shares of stock at $30 each, your average purchase price would be $37.50. If the stock returns to its original price of $45.00, you would have made about 16% profit.

Averaging down trading strategy backtest

An average down trading strategy backtest with trading rules, settings, and historical performance is coming shortly.

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