This topic will continue to remain evergreen because of the sheer number of newbie traders who just cannot understand this concept.
Transaction volumes impact price. When there are price dips, opportunities to get stocks at lower prices in an uptrend present themselves. As a retail trader, you need to understand how to capitalize on drawdowns that occur on positions that are held, especially if recovery and eventual profit performance are expected. This has to do with the concept of averaging down entry prices to reduce the overall cost of the trade. What follows is an explanation of this concept and how it applies to trading.
The concept of Averaging down is a principle of buying sequential quantities of a currency pair or an asset as the price is falling, which eventually leads to a lower average entry price.
A successful deployment of the averaging down technique requires that the trader must understand the following:
Averaging down is best practised when the market is in a retracement during an uptrend. Averaging down became a practice in trading because no trader has the ability to pick out an exact market bottom. A trader may decide to buy at X price, only for the asset to drop further to a new price low. When the trader is sure that prices will recover, the trader may buy more of the investment at a lower price. This practice serves the following purposes:
Let us say, for instance, that you purchased 100 units of cryptocurrency TKAN at $30 per unit, but the price of this stock fell to $15. This entry gives an entry amount of $3,000, but the crypto portfolio would only be worth $1500 with the 50% dip. Most panicked investors would start to sell, ensuring that they get a loss of $1500.
However, a seasoned investor who believes that the price of the crypto asset will recover may decide to add another 100 crypto units to the portfolio, but this time the price would be at $15 per unit. The total cost of the purchase would now be $4500, but the investor would have 200 units of the crypto asset.
The average price of the 200-unit crypto portfolio would be 4500/200 = $22.5
By reducing the average price of the crypto purchase unit to $22.5, the trader would have decreased the purchase price by $7.50 per unit. However, the price reduction does not mean that the asset position has become profitable. At $15, the asset positioning would still be down by $7.50 ($22.50 - $15.00). Therefore, the trader would still need the asset price to start recovering to the point where it exceeds the $22.50 average price for the position to become profitable. Sometimes, there are situations where the trader would need to do several rounds of such dip-buying, especially if the trade volume is substantial and the trader has a large pool of funds to trade. No matter the number of times the trader averages down, the end result is that the position has to climb above the average entry price to become profitable.
Averaging down is not a random event where the trader decides to buy at a lower price at any time to add to an existing position. When you average down for asset trades where you own the assets purchased (e.g. stocks or cryptocurrencies), you can get away with an entry that is not ideal if the stock or crypto has a long term potential for appreciation. However, you do not have such liberties if you are trading a leveraged asset such as a CFD where you do not own the asset and only purchase a contract based on price movements. Entries must be spot on, and there are ways to do it. Here are steps to follow if you are to average down successfully.
It is a normal thing for prices to dip in an uptrend. This is a retracement or correction and usually occurs in those who got into the trend early are taking profits. This scenario is purely a supply-based price move that results in a retracement. Such a retracement can be gauged using the Fibonacci numbers or using the percentage retracement rules. In such circumstances, you can buy a price dip to any of these retracement levels to average down your entry price.
Change in fundamentals negates the averaging down principle. If the sentiment on an asset has changed due to a major announcement, this can lead to a potential reversal of a trend. In this circumstance, averaging down will lead to losses because a trend reversal is a major move that outstrips the levels of any retracement or price correction.
The problem for average investors is distinguishing between a retracement or correction and a complete reversal.
Detecting dip-buying areas for the averaging down price entry method requires that the trader uses tools to detect support (for BUY trades) and resistance (SELL trades). Since the averaging down technique is mostly used for buy trades, the following tools that show support levels should be used:
The averaging down technique works better when the investment horizon is longer. A long-term investment horizon gives the asset more time to work its way into the profit zone. Short-term focus puts the trader and the position under pressure and could jeopardise the averaging technique.
Averaging down to get the best pricing works best for trades that confer ownership of the assets. That is why stocks and cryptocurrencies are the best suited for this trade technique. You can also apply the averaging down technique for forex and other CFD assets, but these trades' risk profile is more significant.