Albert0373
08-13-2007, 05:21 AM
Investors average down, buying more shares of a sinking stock to decrease the average price per share they have paid. This strategy is like throwing good money after bad, and is hardly ever effective. Nevertheless, individual investors seem to continually engage in this practice.
Professionals are much more likely to 'Average Up.' They acquire more shares as the stock price climbs and the momentum of the company rises. They see increasing share prices as a confirmation of their research success, rather than a profit-taking opportunity.
Example:
If you buy 1000 shares of a stock @ $1 and the pps goes to $2 then you made a $1000 profit.
Now if you average up when the pps gets to $1.5 with another 1000 shares bought, your average pps will be $1.25. When the pps continues up to 2$ then you have made $1500 in profits.
$500 profit more for 1000 more shares bought @ $1.5 thus for an additional investment of 1000*1.5= $1500. It doesn't look good regarding the investment/profits ratio since you make $1500 profit over a $2500 investment (60%) instead of $1000 over a $1000 investment (100%).
But since you should average up on winning stocks, the risk is lesser and the more a stock goes up, the more you feel you made the right choice. Because the profits compound.
For instance, IMH. I bought at 1.75 and waited for a movement upwards and other indicators to confirm that its a possible winner and I added more shares at a higher price in anticipation of a bigger move.
Inversely, when you average down on a stock, you could keep losing money until you lose everything. But its also a good strategy to be in the green again if you bought the stock at its 52-week high and the stock wont reach it again but will trade at a slightly lower level. SO THINK TWICE before averaging down and do it only if you are sure the stock has hit the bottom of the bottom AND when it is expecting some precursor that will move it up again in the SHORT TERM. Like financials or a product launch or whatever ...and I repeat in the short term, because the money could be used elsewhere until it is really time to average down.
One more tactic I often use: is averaging down to cut my losses and not to hold for a future gain. Lets take an example: If I buy 1000 shares of a stock @ $1 and the next day it just drops hard and brutal to $0.50, I will sell to cut my losses but if I do it, I would lose $500. Observe the stock, if it is rebounding and trading again between $0.50 and $0.75, buy 1000 more shares of the stock @ $0.5/0.55 averaging down the cost to 0.75$ and sell the stock @ $0.65/0.7. You would then lose around $150 instead of the $500. Timing is everything. You cannot use this tactic for every stock but it works well with some of them.
One more thing, setting stop losses.
There is no magic number at which to cut your losses.
It all depends on the stock.
When the stock has a big market cap and low volatility, it is usual to set a 7-8% stop loss.
When it is a mid cap with mid volatility, it is usual to set it to 15-20%
When it is a low cap with high volatility, you can set it up to 30-40%
You can also have big cap and high volatility etc .... Its upon you to set a limit depending on the risk you want to take and the period you are willing to hold a stock. Some reversals can take a year or more.
A good strategy is to set a mental stop loss and follow the stock closely.
You then change the stop accordingly to the new variables affecting the pps.
But if you cannot keep track of the stock, set a high stop loss just in case and another small one in your mind.
Professionals are much more likely to 'Average Up.' They acquire more shares as the stock price climbs and the momentum of the company rises. They see increasing share prices as a confirmation of their research success, rather than a profit-taking opportunity.
Example:
If you buy 1000 shares of a stock @ $1 and the pps goes to $2 then you made a $1000 profit.
Now if you average up when the pps gets to $1.5 with another 1000 shares bought, your average pps will be $1.25. When the pps continues up to 2$ then you have made $1500 in profits.
$500 profit more for 1000 more shares bought @ $1.5 thus for an additional investment of 1000*1.5= $1500. It doesn't look good regarding the investment/profits ratio since you make $1500 profit over a $2500 investment (60%) instead of $1000 over a $1000 investment (100%).
But since you should average up on winning stocks, the risk is lesser and the more a stock goes up, the more you feel you made the right choice. Because the profits compound.
For instance, IMH. I bought at 1.75 and waited for a movement upwards and other indicators to confirm that its a possible winner and I added more shares at a higher price in anticipation of a bigger move.
Inversely, when you average down on a stock, you could keep losing money until you lose everything. But its also a good strategy to be in the green again if you bought the stock at its 52-week high and the stock wont reach it again but will trade at a slightly lower level. SO THINK TWICE before averaging down and do it only if you are sure the stock has hit the bottom of the bottom AND when it is expecting some precursor that will move it up again in the SHORT TERM. Like financials or a product launch or whatever ...and I repeat in the short term, because the money could be used elsewhere until it is really time to average down.
One more tactic I often use: is averaging down to cut my losses and not to hold for a future gain. Lets take an example: If I buy 1000 shares of a stock @ $1 and the next day it just drops hard and brutal to $0.50, I will sell to cut my losses but if I do it, I would lose $500. Observe the stock, if it is rebounding and trading again between $0.50 and $0.75, buy 1000 more shares of the stock @ $0.5/0.55 averaging down the cost to 0.75$ and sell the stock @ $0.65/0.7. You would then lose around $150 instead of the $500. Timing is everything. You cannot use this tactic for every stock but it works well with some of them.
One more thing, setting stop losses.
There is no magic number at which to cut your losses.
It all depends on the stock.
When the stock has a big market cap and low volatility, it is usual to set a 7-8% stop loss.
When it is a mid cap with mid volatility, it is usual to set it to 15-20%
When it is a low cap with high volatility, you can set it up to 30-40%
You can also have big cap and high volatility etc .... Its upon you to set a limit depending on the risk you want to take and the period you are willing to hold a stock. Some reversals can take a year or more.
A good strategy is to set a mental stop loss and follow the stock closely.
You then change the stop accordingly to the new variables affecting the pps.
But if you cannot keep track of the stock, set a high stop loss just in case and another small one in your mind.