Averaging down means an attempt done by investor to buy stock that he or she already owns when the stock price drops below the stock's initial buying time therefore the stock earning price will be lower. There are two purpose of averaging down done by investor, the one wanted to ensure that he or she buy the stock at lowest price and the other is for lowering the break even point.
Since only God, some of you might say Buddha or Brahma or Shiva, knows how the stock price will move tomorrow, I did not recommend averaging down to lower the break even point. In this way an investor will become a speculator, that is when the stock price declines, he or she will buy the stock then speculate the stock price will increase to reach the break even point and sell it just after the price increases a bit.
Therefore I recommend to use averaging down to get lower average stock cost of ownership. For example, when the stock price reaches a bottom price, the you can buy it. Then the stock price might rise and fall to reach another lower bottom. This is what is called by double bottom. At this time you can then buy again, if you are sure of what you are doing, then buy twice the number of the first buying! Please refer to the picture below (from Yahoo Finance) for the double bottom scenario. I've put circle on the double bottom price.
However if the stock price rises and could not manage to reach the 2nd bottom, you already have undervalued stock and then enjoy the rise. Triple bottom might happens in some occasion, when that happens, then you can average down 3 times to get the stock at its lowest price.
However you will need to remember: you need to choose good stock, from a solid company that is undervalued to do this trick! Otherwise you will end up with loosing more! I've done once, I hope you won't do it!
This is my failure experience on averaging down. I've bought some stock at pretty high price, therefore I've decided to average down the stock, so that I'll require only smaller stock price gain to get profit (remember not lowering the break even). This is not a very good idea, since averaging down requires tremendous amount of money, and averaging down will only make fake profit if the stock price only increases to less than the highest buying price. However I have no choice, since I bought it at too high.
I'll give you the calculation here:
- Scenario 1: I've bought 10 lots of BUMI stock at 6800, and then 10 lots at 5800 and another 10 at 5300. Imagine now the price is at 6000 and stays there. How much do I earn? I've lost 800 x 500 x 10 = Rp 4.000.000, and earned 200 x 500 x 10 + 700 x 500 x 10 = 4.500.000. So in conclusion I've earned 500.000. Good enough for hedging loss.
- Scenario 2: Now imagine, if I sell the BUMI stock at 6500, I'll lost 1.500.000. Then I buy that again at 5300, when the stock price goes back to 6000, this is that I've earned: 700 x 500 x 10 = 3.500.000, in total I'll earn 2.000.000. 4 times the original figures, with about 1/3 amount of investment. Quite surprising right?
- Average down is for hedging loss when it is too late (the price is already too low for feasible cut loss, and the stock price is unlikely to go lower), but it is not substitute for good stock choice.
- However, on scenario 1, if the stock price continue to decline down to 5000 and stays there, I'll loss lots and lots amount of money (1800 + 800 + 300) * 10 * 500 = 14.500.000, compared to scenario 2, cutting loss and buying back at 5300, I'll only loose 300 x 500 x 10 + 1.500.000 = 3.000.000.
- Thinking about averaging down? Think again!