Averaging Down: A Strategy to Lower Your Average Purchase Price

Averaging down is a trading strategy where an investor buys additional units of an asset as its price declines. The goal is to reduce the average cost per unit of the asset, thereby potentially increasing profits if the price rebounds. This approach is commonly used in stocks, forex (FX), indices, and CFDs trading, especially when traders believe that the asset’s price drop is temporary or unjustified.

How Averaging Down Works

Imagine you purchase 100 shares of a stock at $50 each. The total investment is $5,000. If the price falls to $40, your initial investment has lost value. By buying another 100 shares at $40, you increase your total shares to 200, and your total investment becomes $5,000 + $4,000 = $9,000. The new average cost per share is calculated by dividing the total investment by the total shares:

Formula: Average Purchase Price = (Initial Investment + Additional Investment) / (Initial Shares + Additional Shares)

In this example:

Average Purchase Price = $9,000 / 200 shares = $45 per share

By averaging down, the average price per share drops from $50 to $45, meaning the asset doesn’t have to recover all the way to $50 to break even—only to $45.

Real-Life Example

Consider a trader who buys 1,000 units of EUR/USD at 1.2000 (meaning they spend $1,200,000 in notional terms if using standard lot sizes). After the price falls to 1.1800, instead of selling to cut losses, the trader buys another 1,000 units at the lower price. The average price becomes:

Average Price = [(1,000 × 1.2000) + (1,000 × 1.1800)] / (1,000 + 1,000) = (1,200 + 1,180) / 2 = 1.1900

Now, instead of needing the pair to rise back to 1.2000 to break even, the price only needs to climb back to 1.1900.

Common Mistakes and Misconceptions

While averaging down can be an effective tool, it carries significant risks. One common mistake is using this strategy without assessing the underlying reasons for the price decline. If a company’s fundamentals deteriorate or market conditions worsen, averaging down can deepen losses rather than reduce them.

Another misconception is that averaging down guarantees profit. It only improves the break-even point but does not prevent losses if the asset continues to decline. For leveraged products like CFDs or forex, this approach can quickly lead to margin calls if the asset price drops significantly.

Additionally, averaging down can encourage emotional trading by leading traders to hold onto losing positions longer than they should, hoping for a rebound that may never come. Discipline and risk management—such as setting stop-loss orders—are crucial when employing this strategy.

Related Queries

Traders often ask: “Is averaging down a good strategy?”, “How to average down in forex?”, and “What are the risks of averaging down stocks?” The answer depends largely on market conditions, the asset’s fundamentals, and the trader’s risk tolerance. Averaging down works best when the asset’s price drop is temporary or due to market noise rather than fundamental deterioration.

Conclusion

Averaging down is a double-edged sword. It allows traders to lower their average purchase price and potentially enhance returns if the market recovers. However, it should be used cautiously, with a clear understanding of the asset’s prospects and proper risk management. Always analyze why the price has decreased before deciding to buy more, and avoid letting hope alone drive your decisions.