It involves buying more shares after there is a fall in stock prices following the initial purchase. The strategy leads to lowering the average cost of all the shares held thus lowering the breakeven point.
Here‘s an example of how averaging down works.
Consider you have purchased 200 shares of Tata Chemical for Rs660 today and prices correct the following day. Suppose at this stage you are down 13% on your initial investment. Now you can do two things i.e. wait for the stock to bounce back to your buying price or average your trade by buying 200 more shares at Rs570.
If you average, your holding is now 400 shares at an overall cost of Rs2,46,000. The average cost is Rs615 per share. Now when the stock bounces back to 660 levels and you decide to sell all the shares, you will end up making a profit of Rs45 per share i.e. a gain of 7.31%. By gaining 15% on your second purchase, you are able to reduce the breakeven point and manage to come out early.
If a trader does not consider averaging his position, he is in a no-profit no-loss situation even after the stock witnesses a bounce of close to ~17% from its lows.
Lot of traders prefer to buy more towards their winning trades rather than averaging their losses. In this strategy, traders tend to buy new units when they are convinced that the original trend in the stock is still intact and there is significant potential in the stock.
Here‘s an example of how averaging up works.
Consider a trader A has a bullish view on Avanti Feeds and purchases 100 shares at Rs1,660. The stock, after a sideways consolidation for the next few days, moves higher than its initial buying price. The trader at this point is convinced that his analysis in the stock is right and goes on to make fresh purchases at Rs1,960 and Rs2,250 respectively. These are the levels from which he expects the stock to trend higher, thus taking the overall cost of the transactions to Rs5,87,000. The trader, thus, ends up buying 300 shares at an average cost of Rs1,957 per share. Conversely, a trader B who had the same initial view as trader A, but did not have the conviction to average up his position, ended up with 100 shares. When the traders exit their position at 2,800, Trader A makes a net profit of Rs2,52,900 compared of a net profit of Rs1,14,000 of trader B. This clearly demonstrates how averaging up strategy can be profitable if made use of in a bull market.
The risk arises for trader A when there is a reversal in trend since he has pushed the average price per stock higher with each successive purchase. The different ways in which we can average our winning positions is covered under pyramiding.
Pyramiding/ compounding a position
Pyramiding is a trading strategy, which involves adding to existing positions, as price moves in the desired direction. Fresh positions are taken at the discretion of the trader, based on his study of moving average breakouts, chart pattern breakouts, penetration of resistance levels, etc. There are different types of pyramiding strategies. It is an aggressive trading style suitable only for those who have the capacity to bear risk and have the knowledge to control it.
The risk is very high in this strategy. As long as the trend is maintained, the trader continues to enjoy profits but it quickly turns against the trader when price trend reverses. The reason for this being the trader tends to have the largest position right at the top/ bottom and in case there is a sharp change in prices due to a market crash or gap down/up opening, it tends to become extremely difficult to curtail the losses as per plan.
The standard pyramid, which is also known as the scaled-down pyramid or upright pyramid, involves buying the largest position right at the start and adding fresh positions in a scaled down manner. For instance, if the first trade involved buying 1,000 shares, then as the price moves to the next desired level, 500 more shares are added following adding of 250 more shares and then 125 till the desired quantity is purchased. We end up having 1,875 shares at the top/ bottom.
Example: As per the upright pyramid strategy, the trader buys shares of Balkrishna Industries in a scaled manner. He purchases his highest quantity of 1,000 shares right at the start and makes incremental purchases as the uptrend in the stock continues, ending up with 1,750 shares and continues to hold the position till the uptrend persists.
The inverted pyramid is the next variant of pyramiding. It involves adding shares in equal increments at desired levels. For example, if the initial trade was for 1,000 shares, then as price moves to the next predetermined level we add more 1,000 shares, then if the price continues we add 1,000 more, then a 1,000 more, ultimately ending with 4,000 shares. Risk in this strategy is greater compared to the standard pyramid.