What is Averaging?
Averaging, in the stock market, is a bundle of comprehensive trading strategies that involve the fundamental principle of reducing or increasing your share prices to overcome market volatility. There are multiple kinds of averaging strategies a trader can use in a variety of market settings. For instance, in an emerging bull market, the price of a newly acquired unit acquired decreases due to averaging.
In this case, one’s holding is incrementally increased with the help of strong fundamentals like an increase in PAT, and consistent revenue growth. On the other hand, in a falling market, an averaging strategy is employed to reduce one’s cost of loss, thereby making the units purchased higher in revenue. Hence, averaging is not limited to losing trades only. Here’s an introduction to the different ways you can average your stocks.
How to Use Averaging in Stock Market’s Cash Segment
Here are the various averaging strategies employed by traders in the stock market’s cash segment.
1. Averaging Down
This is one of the most popularly employed averaging strategies. It is carried out by acquiring more shares after there is a fall in the share price following its initial purchase. Buying more shares means the average cost of all shares held is lowered, and this leads to the breakeven point lowering as well. This is explained with the following example. Assume A and B both have a bullish judgment on Asian Paints’ performance. They have the same profit target of ₹1,250 on its stock. A chooses to invest ₹1 lakh of investible capital as a lump sum at a point X.
B analyzes the volatility of the stock, invests half of her investible capital of ₹1 lakh of at point X and receives a second opportunity to invest the remaining ₹50,000 at point Y, which is her support level. This averaging strategy allowed B to reduce her breakeven point to ₹1,121. She is able to exit her trade profitably once the share price reaches this point. Alternatively, A must wait for the Asian paint share price to reach ₹1,180, which was his initial purchasing price so that he can reach breakeven, which leads to lower profits.
2. Averaging Up
Averaging up is a widely used strategy in the bull market. Using this strategy, traders buy new units if they are assured that the original trend of the stock is intact with significant growth potential. Consider A, with a bullish view on XYZ stock, buys 100 of its shares at ₹1,660. In the next few days, assume the XYZ stock grows from this initial buying price. Now convinced of his bullish judgment, A makes new purchases at ₹1960 and ₹2250.
As A predicted that the stock would trade higher at these levels, he took his overall transaction cost up to ₹5,87,000. Using this strategy, A buys 300 shares of XYZ at an average share price of ₹1,957. In contrast, B with the same bullish expectation, who did not average up his position, ended with 100 shares. When A exits his position, his net profit is ₹2,52,900. Alternatively, when B exits his position, the net profit is ₹1,14,000. Hence, averaging up can be very profitable when used in a bull market.
Pyramiding is an aggressive trading strategy that involves compounding one’s existing positions, as the share price moves in a desirable direction. It classifies as an averaging strategy due to the nature of growing the average price by putting in fresh positions into a trade where they expect bullish growth. It is suitable for those who can manage high-risk situations. A fresh position is always taken on the trader’s discretion based on an assessment of chart pattern breakouts, moving average breakouts, penetration of resistance levels and other technical analysis.
As long as the trader is able to ride the trend, the compounding works well in their favor. However, it can quickly turn against them once the price trend reverses. A pyramid trader tends to take the highest or lowest position in a trend and when the trendline reverses it becomes difficult to curtail losses. A stop-loss is necessary to mitigate high losses. A typical or standard pyramid strategy involves buying the largest position in a company at the start followed by putting in fresh positions in a scaled-down way. Then there is also the inverted pyramid that involves adding fresh positions to a valued stock in equal increments.
To conclude, averaging in the stock market is a commonly used trading strategy that involves scaling up or scaling down on the share price to mitigate market volatility. There are many ways to average one’s prices: up, down or using a pyramid strategy. It is a high-risk strategy suitable for seasoned traders.