Definition
The term averaging down refers to an investment strategy that involves buying additional shares of stock at a lower price than originally paid. Averaging down effectively lowers the average price paid per share of stock.
Explanation
An investment strategy that's oftentimes grounded in myth is averaging down. The concept can apply to the purchase of stock as well as options. The process involves buying additional shares of stock when the stock's price is falling. By doing so, the investor's average price per share is lowered. The investor hopes the stock's price will eventually rise, and the lower average price will result in additional profits.
Unfortunately, when a stock's price is falling it's oftentimes the result of information that lowers the perceived or fundamental value of the security. In fact, when a stock's price falls there is no guarantee it will rise in the near term. Following an averaging down strategy also results in the investor holding additional shares of the same stock, which may result in an overweighting of the security in their portfolio.
Example
An investor purchased 100 shares of Company ABC's common stock at $40.00 per share. Shortly afterwards, the price of Company ABC's stock declined to $20.00 per share. The investor subscribes to the averaging down strategy and purchases an additional 100 shares of Company ABC's stock at $20.00 per share, bringing the average cost to:
= (100 shares x $40.00 per share + 100 shares x $20.00 per share) / 200 shares= ($4,000 + $2,000) / 200 shares, or $30.00 per share
Related Terms
The term calendar spread refers to a neutral strategy that involves options with the same underlying stock and strike price but different expiration dates. Calendar spreads are a low risk, low return option strategy that profits from volatility and the passage of time.
Moneyzine EditorJanuary 9th, 2024
The term butterfly spread refers to a neutral strategy involving a combination of bull and bear spreads using three strike prices. Butterfly spreads are considered a limited profit, limited risk option strategy.Moneyzine EditorNovember 6th, 2024
The term box spread refers to a four-sided option involving a bear and bull spread with identical expiration dates. Box spreads can provide the investor with an arbitrage opportunity, with the trader assuming a nearly riskless position.Moneyzine EditorJanuary 9th, 2024
The term backspread refers to an investment strategy that involves buying more long position options than short positions. Backspreads provide the investor with relatively large exposure to any movement in the underlying security.Moneyzine EditorNovember 6th, 2024
