Is There a Risk to Averaging Down?
March 6, 2017, 3:11 pm
We’ve all had that one stock that reverses and plummets 10%, 15% or more the day after you bought it. There are several strategies to manage that red ink, but two well-known ones are simply cutting your losses or averaging down (buying more shares in the company at a lower price than you initially purchased, which brings the average price you’ve paid on all your shares down).
Let’s say you bought 10 shares of XYZ stock trading at $100 (a total of $1,000). However, following a broader market pullback the stock drops 30% to $70 a share. You purchase 10 more shares of XYZ (or $700 worth), which brings the average purchase price to $85 a share ($1,000 + $700)/20 shares = $85 a share). You’ve lowered the original cost by $15.
Now averaging down is a bit of a double-edged sword. By lowering your initial cost, you stand to make a lot more money if the stock reverses to the upside. But if it continues falling, your loss will be greater since you own more shares. So the big question becomes: is it worth it?
My answer is that it depends. For longer-term investments, if you have a strong conviction that the market is declining and the weakness is not company-specific, it’s certainly something think about. However, you may want to consider only adding by a half or fourth position so you’re not overweight in that stock.
For options trades, I really don’t encourage it. You have to respect the action in the stock/option when you are dealing with a trade that has a certain expiration date. This is much different than when you are looking at a long-term investment where short-term movements in the stock might create buying opportunities. When you are dealing with a near-term expiration, time is the enemy and it is best to simply cut your losses. In some cases you can extend the time period by rolling the option, but it depends on if there are still enough near-term catalysts that would warrant the added time.
However, short-term stock trades are more of a gray area. There are several reasons why I don’t normally add to stocks that are down. When I’m holding a position for just a few months, I’d rather cut my losses and put the available cash into new trade set-ups. I also take risk management very seriously. If a stock gets down around 10%, I need high conviction it can turn around to stay with it. And if the reasons we got into a trade to begin with change – technical or fundamental – I will usually sell.
That said, when a stock is down for reasons that don’t change my thesis and look to be temporary, and when I have exceptionally high confidence that it will move higher, I may add a second position to lower my cost basis and make that money back faster. I don’t do this very often, though.
One of the challenges with these second positions – and your own dollar-cost averaging activity – is that conviction is a moving target. I have to have the same level or higher conviction in the stock than when I first opened the trade. Because I place a great deal of emphasis on the charts for stock trades, a move to the downside can weaken the technical situation or prolong recovery. It may improve the long-term fundamental opportunity, but that’s not my goal here.
At the end of the day, it really depends on your risk tolerance and what you’re comfortable with. If averaging down is something you’d like to try, just be aware of the benefits as well as the risks before you do it.