Do you know how to average down? Ever given averaging down some serious thought? Cramer says that you should average down in 4 buys. Is that right? How about 10 times? What about twice? Which is better? I hate when people say, oh 4 times is a good number because somebody said it was. So let’s explore the dynamics behind averaging down and how purchase count affects the overall share price.
Here is the scenario, I am going to average down a stock that is right now trading in its 20’s, to 8 dollars. This means the stock has a 60% drop, not to dissimilar to current situations. For commission costs I am going to use 9.90 per trade and I am going to assume that your pocket book can only handle about a 100 shares. That means your exposure is going to be at a most 2000 to 2500 USD.
Let’s say that I am going to follow Cramer’s advice and I am going to do four buys; 20, 16, 12, and 8. The cost structure is as follows.
In this scenario the average cost of a share that drops down to 8 USD is 13.99. That makes your average down a premium of 74% over the 8 USD. That might sound like quite a bit, but when a share plunges it actually is not that much. Remember that the value of the share was chopped in half.
Ok, now lets say instead of 4 buys you buy 7 times, with the last purchase being 8 USD. Following is the cost structure.
In this scenario you also have a 112 shares, but your average cost of the share is 14.12. With 7 buys in lieu of 4 you have an average share price that is 0.87% higher. Putting this into context by buying 7 times you have a share price premium that is equal to the profit of a single average good day.
Though, why should you buy in smaller chunks? The answer is that you can’t predict when the share price is going to bottom. By buying less often with bigger gaps you risk missing good average down opportunities.
For example, what if the stock dropped to say 9.90? In the case of purchasing in 4 blocks the 8 USD purchase will not trigger. Though in the case of purchasing 7 blocks triggered will be 10, but not 8. The new cost structure is as follows.
In this new scenario instead of 7 blocks you have 6, and the cost average is 15.26. In the other case instead of 4 blocks you have 3 and the cost average is 16.17. Since the lowest point of the price is 9.90 the premium of each cost average is 54%, and 63% respectively. The difference in cost average is a bit over 5%.
These new numbers are worlds apart. A 5% cost average is one good week of profits, and the 10% cost premium is potentially a month of profit.
What this shows is that it is to your advantage to average down using smaller amounts. Even when you are paying 9.90 USD per trade for a share count in the teens there is a huge advantage, which I bet you never expected. Though I am not surprised because this type of theory is part of what is called algorithmic trading.