Last Updated on January 31, 2024 by ethinos
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What Is Averaging In Stock Market
Averaging is a set of trading strategies that involve adjusting the average price of the shares held by buying or selling more shares when the market fluctuates. Averaging can be used in different market scenarios and with different objectives. For example, in a rising market, averaging can be used to increase the profit potential by buying more shares at higher prices. In a falling market, averaging in stock market can be used to reduce the loss or break even by buying more shares at lower prices. Here are some of the common ways to average your stocks.
Learn How to Use Averaging in Stock Market’s Cash Segment
These are some of the averaging strategies that traders use in the stock market’s cash segment.
1. Averaging Down
This strategy involves buying more shares when the price falls below the initial purchase price. This lowers the average cost of the shares held and also lowers the break-even point. This strategy can be useful when the trader expects the price to recover in the future. For example, suppose A and B both have a bullish view on ABC Company and have a target price of ₹1,250. A invests ₹1 lakh at point X, while B invests ₹50,000 at point X and another ₹50,000 at point Y, which is lower than point X. By averaging down, B reduces her average cost and break-even point to ₹1,121, while A has to wait for the price to reach ₹1,180 to break even.
2. Averaging Up
This strategy involves buying more shares when the price rises above the initial purchase price. This increases the average cost of the shares held but also increases the profit potential. This strategy can be useful when the trader is confident that the price will continue to rise in the future. For example, suppose A has a bullish view on XYZ stock and buys 100 shares at ₹1,660. After a few days, the price rises and A buys 100 more shares at ₹1,960 and another 100 shares at ₹2,250. By averaging up, A increases his average cost to ₹1,957 but also increases his profit potential. In contrast, B who has the same bullish view but does not average up only has 100 shares.
3. Pyramiding
This strategy involves adding more shares to an existing position as the price moves in a favourable direction. This is similar to averaging up but more aggressive and risky. This strategy can be useful when the trader wants to maximise their returns by riding a strong trend. The trader has to use technical analysis and discretion to decide when and how much to add to their position. For example, suppose A has a bullish view on ABC stock and buys 100 shares at ₹500. After a few days, the price breaks out of a resistance level and A buys 200 more shares at ₹600. After another few days, the price breaks out of another resistance level and A buys 400 more shares at ₹700. By pyramiding, A increases his position size and average cost but also increases his profit potential. However, if the price reverses, A will also face a bigger loss.
Additional Read: Difference Between Common Stock and Preferred Stock?
Investors often aim to pay less and earn more in the stock market. However, accurately predicting share prices and returns can be challenging due to market volatility. This leads many to buy stocks at high prices, hoping for future gains. Here, strategic averaging can be beneficial. If you calculate the average stock price using a simple method, you may incur losses.
Volatility and uncertainty are common in stock markets, making price fluctuations normal. Investors seek to buy stocks at reasonable prices for long-term gains.
Using the appropriate average in the stock market can help determine a rational stock price for better returns. Therefore, average pricing is a key factor in making informed decisions for long-term buying and selling.
Additional Read: Bollinger Bands: An Introduction to the Indicator that Helps Predict Market Volatility
Average pricing in the stock market applies to both buying and selling transactions. It’s crucial because investors typically buy shares of the same company at different prices and times. To calculate the right average price, you should consider the quantities purchased. For example, if you buy 50 shares of ABC Ltd. at ₹120 each and then the price drops to ₹100, you can either wait or invest more. If you invest more, the weighted average price per unit would come down, making it a safer long-term option.
Similarly, when selling shares, calculating the average price can help determine your total earnings. Whether you wait for prices to rise or sell more shares, the weighted average price per unit can impact your selling price.
Additional Read: Volume Weighted Average Price
Averaging is beneficial in both rising and falling markets. It can help accumulate more profits in rising markets and reduce the average purchase price in declining markets. A company’s fundamentals play a role in its suitability for averaging, especially when influenced by industry-specific conditions or market sentiments.
Factors Affecting Stock Average
Four key factors affect stock averaging:
1. Fundamentals: Averaging works best for stocks with strong fundamentals and those in favourable sectors. Poorly performing stocks can become liabilities when averaged.
2. Volatility: Averaging is useful for stocks with price fluctuations and volatility.
3. Futuristic Trends: Stocks showing growth potential, like technology companies, are suitable for averaging.
4. Correcting Mistakes: Averaging can correct mistakes made in stock selection, especially for stocks purchased at their highest prices.
Three methods to lower your average share price in total holdings:
1. Systematic Investment Plan (SIP): Regularly buy smaller lots of your favourite stock during market falls, reducing your average share price over time.
2. Random Averaging: When market drops affect your holdings, decide whether to sell to limit losses or believe in the stock’s potential and use averaging to buy more.
3. Imprudent Averaging: Avoid averaging with fundamentally weak or penny stocks. Instead, consider selling such shares to minimise losses.
In Conclusion
Averaging in the stock market can be a profitable technique if done with proper knowledge and strategy. However, it also involves risk and uncertainty. The investor should be aware of the factors that affect the prices of stocks, such as market conditions, company performance, news events, etc. The investor should also have a clear exit plan and stop-loss in case the price moves against their expectations.
