It often happens in a stock market that we buy a share and its price starts acting negatively and if it continues to fall then often traders tend to sell those shares which results in loss even on fundamentally strong shares.

But instead of selling the fundamentally strong stocks of your portfolio on their fall in prices, if you do their averaging then you could get away with such losses. Therefore it becomes important to know:

The concept of averaging
How does it work
When should we do averaging

What is Averaging Down?

If the prices of the shares we have bought fall, then we can again buy those shares at lower prices which will lower our average buying price and this process is called averaging in the stock market.

For example- We have purchased 100 shares of AB Ltd. for Rs.1000 and the value of our investment is Rs.1,00,000. Now, if the share price of AB Ltd. reduces to Rs.900 per share then we will incur a loss of Rs.100 on each share of AB Ltd. Now we will have three options:

1). Sell: We could either sell shares of AB Ltd. at Rs.900 per share and incur a loss of Rs.10,000 on our AB holding to prevent further losses.

2). Hold: Believe in your stock and consider the fall in prices as a temporary phenomenon and hold onto the stocks of AB Ltd.

3). Buy: The third option is that you can use this fall in prices in your favor and buy more shares of AB Ltd. as they are being sold at discounted prices.

Suppose, we decided to buy 80 shares of AB Ltd. at Rs.900 per share and we again made an investment of Rs. 72,000.

After buying more shares, we will now have 180 shares of AB Ltd and the total investment is 1,72,000. So now, the average buying price of these shares will reduce and the average buying price of these shares will be calculated by the Weighted Average Method and the formula would be:

Average Buying Price = P1Q1 + P2Q2 / Total number of shares, where

P1 = Old buying price of AB Ltd.

Q1 = Old quantity of shares bought at P1 price

P2 = New buying price of AB Ltd.

Q2 = New quantity of shares bought at P2 price

Average Buying Price of AB Ltd. = 1000 x 100 + 900 x 80 / 180 = Rs. 955.56

It means that now we have 180 shares of AB Ltd. which are purchased at Rs. 955.56 per share and now we will be profitable once the share price of AB Ltd. goes over Rs. 955.56.

When should we do Averaging?

We cannot do averaging on every share because if the share price of a company keeps falling then we could incur huge losses. The basic theory of averaging is that the share of a company does not always go in the same direction, there is a rise and fall in the share prices. Before averaging a stock, we should consider these two important points:

1). Average in good and financially strong companies only: Before averaging we should make sure that the company is big and profitable enough and whose Debt to Equity ratio is lower than 1.

Because if a company is not strong enough financially, then it could land in financial stress even at the outset of a temporary problem and its business could get affected severely which could result in its share price plummeting so low that it might not be able to reach at previous levels.

2). Find out the reason for fall in prices: We should figure out why the share prices of the stock we invested in is falling and for we should search for company-related news and look at its quarterly results.

If its quarterly results are falling one year and rising the other and the company is not facing any long-term problems such as any legal issues or fraudulent practices plaguing the company, then you can average the share price of the company.

This method of averaging when the stock prices go down is called the averaging down method and this method is mainly used in bull markets.

What is Pyramiding Trading

Pyramiding Trading is an aggressive trading strategy which involves compounding one’s existing position in a company. In this trading strategy, the focus is on increasing the average price by purchasing fresh shares of a company based on expecting bullish growth of the company.

It is high-risk high-profit as in this strategy a trader takes the highest or lowest positions in a trend, therefore when the price trend goes against you, then it becomes difficult to stop losses.

For example, you bought 100 shares of XYZ Ltd. at Rs.300 per share and expect it to rise further. So, when the share price of XYZ Ltd. soared to Rs.320 you purchased another 100 shares and when it reached to Rs.350, you bought another 100 shares.

This took the average share price to Rs.320 per share and now when you will sell these shares you net profit will rise further thus giving you the benefit of averaging up strategy. Pyramiding Trading is a strategy which is mainly used in bull markets. In this strategy, traders buy new shares if they feel that the share price will keep on increasing and the growth potential of the company will remain intact.

To Conclude

Averaging in the stock market is a high-risk strategy suited for seasoned traders who can assess the market by chart pattern breakouts, penetration of resistance levels, moving average breakouts and other technical analysis. It is a very useful strategy as you can mitigate market volatility and optimize your purchases by averaging your positions up and down or using the pyramid strategy.