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People who are invested in the stock market know that unpredictability is the only constant. Investors frequently struggle with the trials of market volatility, where asset values keep changing. This inherent unpredictability can result in substantial losses for individuals who lack experience in navigating such a dynamic environment. However, within this tumultuous landscape, a remedy exists: averaging in stock market.
Averaging presents itself as a strategic investment approach, offering a solution to the challenges posed by market unpredictability. This guide will highlight the concept of averaging in stock market and its various types in detail.
What is averaging?
Many individuals want to know what is averaging in stock market. Averaging, within the context of the stock market, encompasses a range of comprehensive trading strategies grounded in the fundamental principle of what is average traded price in stock market to navigate market volatility effectively. Various averaging strategies are available for traders to deploy in diverse market scenarios. For instance, in a burgeoning bull market, the price of newly acquired units decreases through averaging.
In this scenario, the holding is gradually expanded by leveraging strong fundamentals such as an increase in profit after tax (PAT) and consistent revenue growth. Conversely, during a market decline, an averaging in stock market comes into play to mitigate losses, thereby elevating the revenue generated from purchased units. Consequently, averaging is not confined to managing losses exclusively. Here’s an introduction to the diverse methods through which you can implement averaging in your stock portfolio.
How does it work?
The concept of averaging in stock market is grounded in a strategic response to the fluctuations in the market. Imagine an investor who, following thorough research, acquires a stock at a specific price, anticipating its potential for growth. However, as markets inherently exhibit unpredictability, they take a downward turn, causing a decline in the stock’s price.
Here’s how averaging works in stock market. Faced with this decline, the investor has several options. They could opt to sell the stock, accept the loss, or choose to hold onto it in the hope of a better future price. Yet, experienced investors often consider another approach – averaging. Instead of merely holding or selling, the investor decides to purchase more of the same stock at the new, lower price. This action effectively reduces the average cost of their overall holdings in that stock.
With this decreased average cost, any future stock price increase doesn’t necessarily need to surpass the initial purchase price for the investor to realise gains. Essentially, the investor is capitalising on the market’s downturn, believing the stock’s value will rise over time. This approach provides a cushion against immediate losses and positions the investor for potential future profits, especially if their long-term assessment of the stock’s value proves accurate.
Types of averaging strategies
The following are different types of averaging in stock market used by stock market traders and investors:
Averaging down entails purchasing more shares of a specific stock when its price decreases, reducing the average cost per share. In this strategy, a position is initiated when the price falls below the trader’s original purchase price.
For instance, if you initially acquire 100 shares at ₹ 300 (for ₹ 30,000), and the stock price subsequently drops to ₹ 200, resulting in a loss of ₹ 100 per share, you face a decision. You can either wait for the stock price to recover or opt to buy additional shares at a lower price. Choosing the latter option, known as averaging down, allows you to decrease your average holding cost. Suppose you decide to pursue this strategy and purchase an additional 150 shares at ₹ 200. This action reduces the average holding cost to ₹ 240 (₹ 60,000/250 shares).
Through averaging in stock market, your holding aligns more closely with the current market price. Even with a modest rebound in the share price, your position has the potential to become profitable.
Averaging up involves acquiring more shares of a specific stock as its price rises, increasing the average cost per share. Despite the elevation in the average cost, averaging up has the potential to enhance returns when entering an upward trend significantly.
This strategy proves effective when the investor anticipates continued upward movement in the stock price, capitalising on momentum in a rising market. For instance, let’s say you initially purchase 100 shares at ₹ 300 with the intention to sell when the price reaches ₹ 350. Convinced of a sustained bullish market, you incrementally add 100 shares at ₹ 310, ₹ 320, ₹ 330, and ₹ 340. Consequently, you now hold 500 shares acquired at various prices, resulting in an average cost of ₹ 320.
By averaging up, you have 500 shares in your portfolio at an average cost below the current market price. Therefore, averaging up can be a lucrative strategy, mainly when applied in a bull market.
Pyramiding represents a form of averaging up strategy in which the trader continuously acquires the stock at various price levels. In this approach, the trader expands their position guided by evaluations of technical indicators, such as breakouts in chart patterns, breaches of resistance levels, moving average breakouts, and other aspects of technical analysis.
When should we do averaging?
Applying averaging to every stock is not feasible, as persistent declines in a company’s share price may lead to substantial losses. The fundamental principle of averaging is grounded in recognising that a company’s share value does not consistently move in a singular direction; instead, it undergoes upward and downward fluctuations. Prior to initiating averaging on a stock, careful consideration should be given to these two critical points:
Average in good and financially strong companies only
Before implementing averaging in stock market, ensuring that the company is sufficiently large, profitable, and maintains a Debt-to-Equity ratio lower than 1 is essential. This precaution is crucial because if a company lacks financial strength, even a transient issue could lead to financial distress. Such vulnerability may severely impact its business, causing its share price to decline significantly, potentially preventing it from returning to previous levels.
Find out the reason for fall in prices
Investigating the reasons behind the decline in the share prices of the stock we’ve invested in is crucial. We should actively search for company-related news and analyse its quarterly results. Suppose the company’s quarterly performance fluctuates from one year to another, without any significant long-term issues like legal problems or fraudulent practices. In that case, it may be appropriate to consider averaging the share price.
This approach of averaging down, employed when stock prices decrease, is known as the averaging down method. Typically, this method is applied in bull markets.
The choice of an averaging in stock market depends on the type of investment you undertake. It is recommended to apply this strategy to blue-chip companies or equities with strong fundamentals for optimal returns. A fundamental analysis of the company’s value, management quality, core offerings, and balance sheet strength is essential to make an informed decision. Investing in a robust company carries a reasonable chance of recovery, even in the face of a market downturn.
The application of the averaging method is inherently linked to an extended time horizon. Consequently, it may not be suitable for traders, particularly during prolonged bearish trends, as it has the potential to amplify short-term losses. Nevertheless, it still proves advantageous when employed as a long-term investing strategy.
The advantage of employing an averaging method is that, in the event of future stock price increases, the investor can still achieve a profit or experience only a minimal loss, provided it doesn’t reach the initial purchase price.
Avoid employing the averaging method in the following scenarios:
When the company is in a precarious state, with uncertainties about its prospects, averaging down can elevate the risk associated with its stock.
Averaging up in a market lacking fundamental support may lead to substantial losses if there is a sudden reversal shortly after implementing the averaging up strategy