Stock Average Down: What It Is, How It Works, Pros & Cons

Buy low, sell high. No adage about trading rings truer, yet it also belies the difficulty of making money off trading. Timing the market is deceptively tricky, which is why many experienced traders who invest in stocks average down.

Knowing when and how to average down a stock provides traders with a valuable technique to use in algorithmic trading strategies. 

What is averaging down in stocks?

When an investor averages down (also known as “buying the dip”), they purchase shares in a stock they already own after it experiences a price drop. This results in a lower average price per share, which means the price doesn’t need to rise as high for the overall position to become profitable.

Imagine you buy 100 shares of stock at $10 per share. The price then falls to $9, and you purchase an additional 100 shares. By purchasing 100 shares for $1 less, your average cost per share falls from $10 to $9.50.

If you stuck with your initial purchase of 100 shares at $10, the stock price would’ve needed to rise above $10 for your initial 100 shares to turn a profit. Buying an additional $100 at $9 allows you to break even at $9.50. 

Many traders rely on an average down stock calculator to calculate their new break-even price. Alternatively, you can use this average down stock formula to calculate it:

[(# of shares ✕ initial purchase price) + (# of shares ✕ second purchase price)] ∕ total # of shares

Here is how it looks for the above example:

[(100 ✕ $10) + (100 ✕ $9)] ∕ 100 = $9.50

Averaging down functions similarly to dollar-cost averaging, which refers to making regular investments at specific intervals regardless of price movement. Like dollar-cost averaging, averaging down allows investors to enter the market in a particular stock at a discounted price. 

Reasons to average down stock

Although traders occasionally use it as a standalone strategy, averaging down stocks often functions as part of an overall strategy to realize short- or long-term capital gains.

Reasons to average down include the following:

Lowering the break-even point

The most immediate benefit gained from averaging down is lowering the break-even point on an investment. With a reduction in the break-even point, the stock price doesn’t need to rise as high to begin realizing a positive investment return, making it easier to earn a profit. 

In addition to positively impacting your profitability calculation, lowering the break-even point provides cognitive benefits. Many people experience a powerful adverse reaction when a stock falls in value. A lower break-even point can cushion this blow and reduce the emotional urge to sell out of a losing position.

Increased potential for gains

Many buy-and-hold investors adopt averaging down into their investment strategy to increase the potential for gains. Over time, a solid investment can weather temporary price declines and experience net growth. When you average down, you bet on the future upside of a stock in the hopes that any loss you suffer today will be overshadowed by the gains you earn tomorrow. 

The strategy is also popular in value investing, which emphasizes buying “good value” stocks (stocks that sell at a discounted price compared to their intrinsic or book value). Value investors commonly invest in stocks with attractive price-to-book (P/B) ratios that may indicate an undervalued stock.

Buying on a dip gives you a chance to increase your return on investment once stock market sentiment changes and the price of the stock increases. 

Risk management

When a stock price falls, most people tend to experience a strong emotional reaction. We’re biased to interpret price declines as a net negative, which prompts many investors to sell out of a losing position.

In times of high market volatility, some investors adopt the opposite approach and leverage averaging down as a risk management strategy.

When you buy on a dip, you lower your average cost basis. In doing so, you also reduce your overall loss on the investment. This can change a considerable loss into a minor one, thereby preserving the health of your position and total portfolio.

Pros & cons of averaging down on stock

No strategy works in every situation. Along with its potential benefits, averaging stock down can expose you to more significant losses. Knowing when and how to average down requires you to evaluate positions with a calm head and an eye to the future. 

Pros of averaging down

Here are some significant benefits of averaging down:

• Lowering average cost: Averaging down lets you buy more shares of an asset you already have at a discount from your initial cost basis. This reduces your average cost basis, making it easier to break even or earn a profit.

• Increased potential gains: Value investors have long known that buying the dip can yield increased potential for gains, given enough time. By doubling down and increasing your exposure, you also raise your potential profit if the price rebounds. 

• Risk management: No one likes losing money. Averaging down helps you preserve value by reducing your losses per share. When you average down stock, you also lower the value the stock price needs to reach before it becomes profitable. 

Cons of averaging down

Averaging down isn’t always the right move. Here are some potential drawbacks:

• Sunk cost fallacy: A form of cognitive bias, the sunk cost fallacy refers to the tendency to continue pursuing unsuccessful endeavors because you’ve already committed resources. Any money invested in a losing position can’t be unspent—it’s a sunk cost. If you feel compelled to average down stock just because you’ve already made a considerable investment, you may have fallen into the sunk cost fallacy. Sometimes, the best course of action is admitting you bought a lemon and cutting your losses. 

• Overcommitment: When you average down stock, you alter your asset allocation. This can cause the weighted average of the losing position to increase. If the stock price continues to fall, overcommitting can lead to more dramatic losses.

• Uncertain timing: It’s hard to know whether a price decline is a temporary dip or the start of a downward trend. Knowing how to read technical indicators such as Simple Moving Average (SMA) or Moving Average Convergence Divergence (MACD) can help you notice trends, but no indicator is perfect. The stock market thrives on uncertainty, making it difficult to calculate when to average down.

• Psychological stress: No one likes to lose money. By betting on a losing investment, you may compound negative emotions. Over time, the psychological stress of “waiting out the storm” can affect your financial and physical health, making averaging down dangerous to your wallet and mental well-being.

Factor averaging down into your strategy with Composer

It’s easy to incorporate averaging down into your existing stock trading strategy with Composer. 

With threshold trading, you can set a weight percentage range for a stock in your portfolio. When an asset’s weighted average moves outside the target range, it automatically triggers the system to execute trades that return your investments to their desired weights. 

Imagine you hold stock A and stock B at 50–50. If you use threshold trading to set a trigger at 10%, Composer won’t trade until your asset allocation exceeds 60–40. You can then set your strategy to average down by buying more of the lower-weighted asset until the ratio returns to 50%.

Averaging down with threshold trading can save you money, as threshold strategies often trade less than calendar-based settings. Threshold trading can also help you manage portfolio risk by stopping asset allocations from deviating outside your target range. 

With Composer, you can also access pre-programmed trading algorithms (like Buy The Dips, Nasdaq 100) and utilize our user-friendly tools to create your own "Buy The Dips" strategies based on technical indicators —no coding skills required. 

Ready to start building a strategy of your own? Our ChatGPT-4-powered tech lets you set goals using simple, natural language. AI simplifies the process and helps you make informed investment decisions with confidence. Join our platform today to supercharge your investing.