Averaging in Stock Market: Meaning & Examples

Every trader wants to be on the winning side of the game, meaning they want to buy cheap, sell high, and then purchase low. Due to the volatility of the stock market, it is challenging for a trader to perform consistently. Some trades may not go as planned. Averaging in the stock market is one approach that a trader might use to combat volatility.

Averaging in the Stock Market?

In the stock market, averaging is a collection of comprehensive trading methods that utilize the core premise of lowering or raising your share prices to tackle market volatility. A trader can employ several averaging tactics under a range of market conditions. In a nascent bull market, the price of a freshly bought unit lowers owing to averaging.

Averaging in the stock market is not limited to losing transactions; you can use it in rising and declining markets. In a growing bull market, the cost of acquiring a new unit decreases due to averaging. The holding expands gradually and gets support from solid fundamental reasons such as constant revenue growth, rise in PAT, etc. Averaging lowers the cost of loss-making units acquired at higher prices in a decreasing market. You can understand the meaning of averaging in the stock market here.

Many traders utilize the 100-day moving average and the 200-day moving average to determine whether or not to average. Remember, the technical method does not account for long-term changes in the stock’s underlying fundamentals. DMAs can be an excellent starting place, but you must use the above principles to determine whether or not to average your position.

The most apparent averaging issue is when you buy a stock that falls in value. The critical question is whether the stock has entered an intermediate downturn. This has nothing to do with the stock’s quality or the management’s quality. Both of them may be advantageous, but averaging in the stock market may be the incorrect decision. Consider the 2011 instance of L&T. The capital cycle was going down, and investors understood that L&T would be unable to sustain its growth and profitability to justify its values.

Over the next few years, the stock dropped by more than half. Averaging in the stock market is useless when the primary trend alters. The second is an instance in which something fundamentally changes. Consider the last 18 months in the IT and pharmaceutical industries. The value of marquee brands has dropped by more than half due to the regulatory environment becoming more stringent and margins being tighter. When such a fundamental shift occurs, you should avoid averaging your long positions.

How to Use Averaging in Stock Market’s Cash Segment

The following are the numerous averaging tactics that the traders use in the cash section of the stock market.

Averaging Down

This is among the most widely used averaging strategies. It is done by purchasing additional shares if the price falls after the original purchase. Purchasing more shares lowers the estimated cost of all shares held, decreasing the profitability. The following example demonstrates this. Assume that A and B both have a positive outlook on Asian Paints’ performance. They each have an identical profit objective of Rs. 1250 for their investment. A decides to contribute a lump sum of 1 lakh in diversified capital at point X.

B evaluates the stock’s turbulence and invests 50% of her investible money of one lakh at point X, with a second option to invest the remainder 50,000 at point Y, her support level. B decreased her initial investment to 1,121 using this averaging strategy. Once the share price reaches this level, she can profitably exit her bet. Otherwise, A must pause for the Asian paint share price to reach 1,180, his initial purchase price, to break even, resulting in reduced profits.

Averaging Up

In a bull market, averaging higher is a popular approach. Traders use this approach to purchase new units if they are confident that the stock’s initial trend is intact and has strong growth potential. Consider A, who is optimistic about XYZ stock and purchases 100 shares for Rs. 132,800/-. Assume that the XYZ stock rises from this initial purchase price during the next several days. A, now sure of his bullish prediction, make further purchases at Rs. 153,600/- and Rs. 180,000/-.

Pyramiding

Pyramiding is a revolutionary trading technique that entails multiplying one’s current positions as the share price rises. It is classified as an averaging technique because it seeks to increase the average price by introducing new positions into a trade in which they anticipate positive growth. It is appropriate for individuals who are capable of dealing with high-risk scenarios. A new position is always taken at the trader’s discretion based on evaluating chart pattern breakouts, moving average breakouts, resistance level breaching, and other technical analyses.

How Can You Benefit From Averaging?

There are several ways  you can benefit from the averaging of stock prices:

Increasing Profits In Rising Markets

Over time, you can take advantage of price fluctuations by buying stocks at different prices. As the share price rises, buying additional shares at a lower average price allows you to accumulate more profits when you sell them later.

Lowering The Average Purchase Price In Declining Markets

In a market downturn when stock prices are falling, averaging can help lower your average purchase price. If you buy more shares at lower prices, you can reduce the 
rnimpact of market declines on your investment.

Earning More Average Profits In Rising Markets When Selling

During a rising market, you can generate greater profits by selling your shares at a higher average price if you have accumulated shares at various prices. When you decide to sell your shares, the higher average purchase price will yield good profits.

Moreover, Averaging of Stock Market works best when a company’s fundamentals remain strong despite temporary market fluctuations. In order to identify promising companies for averaging strategies, look for factors such as management quality, balance sheet health, valuation parameters, and financial ratios.

Conclusion

The goal is to utilize averaging constructively and for long-term gain. Certain equities have a ton of potential going for them. You will also be unsure of the best price for these stocks. One approach to resolving this difficulty is to average stocks after each decline. This ensures that the stock’s long-term average purchase price is low. The advantage of momentum is that such equities quickly become over-owned. As a result, it offers an opportunity in the shape of occasional corrections that may be exploited to continue buying the stock at more attractive prices. It will assist you in lowering your average cost of keeping the asset. 

To summarise, averaging in the stock market is a popular trading method that includes scaling up or down on the stock price to reduce market volatility. There are several methods for averaging prices: up, down, or employing a pyramid technique. It is a high-risk approach best suited for experienced traders.