What Is Averaging In Stock Market?

Shares are often purchased on a stock market and then the price falls, and traders, even on fundamentally strong shares, tend to sell those shares if the price continues to fall.

If you average your portfolio's fundamentally strong stocks, you can avoid such losses instead of selling them when their prices fall. Therefore it becomes important to know the following:

• The concept of averaging
• How does it work
• When should we do averaging

What is Averaging Down?

Now the main question is - What Is Averaging In Stock Market? When the prices of the shares we have purchased fall, we can buy them again at lower prices, lowering our average buying price. In the stock market, this procedure is known as averaging.

The investment value of our investment is Rs.1,00,000. Let's take the example of 100 shares of AB Ltd. purchased for Rs.1000. Therefore, if AB Ltd.'s share price drops to Rs.900 per share, then we will lose Rs.100 on each share. Now we will have three options:

1). Sell: In order to prevent further losses, we could either sell shares of AB Ltd. at Rs.900 per share or incur a loss of Rs.10,000.

2). Hold: Hold onto your stocks of AB Ltd and consider the drop in prices as a temporary phenomenon.

3). Buy: As AB Ltd. shares are being sold at discounted prices, you can take advantage of the fall in prices to buy more shares.

Assume we purchase 80 shares of AB Ltd. for Rs.900 each. The average buying price of AB Ltd. shares will decrease after we buy more shares. According to the Weighted Average Method, these shares' average buying price would be calculated as follows:

Average Buying Price = P1Q1 + P2Q2 / Total number of shares, where

P1 = Old buying price of AB Ltd.

Q1 = Old quantity of shares bought at P1 price

P2 = New buying price of AB Ltd.

Q2 = New quantity of shares bought at P2 price

Average Buying Price of AB Ltd. = 1000 x 100 + 900 x 80 / 180 = Rs. 955.56

The result is that we now own 180 shares of AB Ltd., which we purchased at Rs. 955.56 per share, and we will be profitable as soon as AB Ltd.'s share price crosses Rs. 955.56.

When should we do Averaging?

In the case of a company whose share price keeps falling, averaging is not possible since losses could be significant. As a company's shares rise and fall, the theory behind averaging is that they don't always move in the same direction. Before averaging a stock, we should consider these two critical points:

1). Average in good and financially strong companies only:

It is important to ensure the company is big and profitable enough before averaging, as well as its Debt to Equity ratio is no more than 1.

Unless a company is financially strong enough, it may find itself in financial stress even at the onset of a temporary problem, which could severely impact its business, resulting in its share price plummeting to a level it may never be able to return to.

2). Find out the reason for the fall in prices:

We need to figure out why the share price of the stock we invested in is falling, and we should look at the company's quarterly results and search for company-related news.

You can average the share price of a company if its quarterly results fall one year and rise the next, and it does not have any long-term problems such as legal issues or fraudulent practices.

An averaging down method is used when stock prices are down, and this method is mainly used during bull markets.

To Conclude

Stock market averaging is a high-risk technique best suited for experienced traders who can evaluate the market using chart pattern breakouts, resistance level penetration, moving average breakouts, and other technical analyses. By averaging your positions up and down or employing the pyramid method, you can minimize market volatility and maximize your purchases with this tactic.