Averaging Down on a stock is a strategy used by investors to buy a stock after its price has moved down from the initial buying price helping the investor to purchase additional shares of the same stock at a lesser price, in turn reducing the average cost of the shares bought.
To help you understand better let us take an example of a share say Excel Industries Ltd.
If an investor bought 100 shares for Rs. 1,750 per share on 8th August 2018 and then when the share price fell to Rs. 1,600 on 13th August, the investor added 85 shares more.
In this scenario the average price for the investor for 185 shares of Excel Industries can be calculated as the sum of multiplied value of the number of shares bought on respective dates with their respective prices and dividing them by total number of shares bought.
Average Price = ((100 * 1750) + (85 * 1600)) / (100 + 85) = Rs. 1681.08 per share
Thus, in this case the investor brought down the average price of the stock bought by him from 1,750 to 1,681.08 by buying additional shares at a lower price. Now any price above this average price will give the investor a profit on the sale of total value of that stock.
This strategy can be good as well as bad for the investors. Let see how -
If the stock rebounds and crosses 1681.08 mark, the strategy will be considered to be beneficial as the investor will make profit on this investment.
However, if the stock price keeps falling further, the investor needs to make a choice whether he wants to keep averaging or bail out of that share by booking a loss.
This strategy of averaging down is considered to be good when an investor is investing in a stock for the long term with depth knowledge and study about the company. In that case, the risk to buy additional shares even at lower prices can pay out and give good returns. However, in cases where the investor is playing the stock due to price volatility, the strategy can be hazardous as the stock prices might keep going down increasing the burden of losses.