Advanced StrategiesUnderstanding Penny Stocks

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Averaging Down

Averaging down is the process of buying more shares of a stock that you had previously acquired, now that the price has dropped.

For example, you buy 1,000 at $2.00, and the stock drops afterwards to $1.00. If you buy another 2,000 shares at $1.00, your average price per share for the 4,000 units is now $1.50. It lowers your break-even point but increases your exposure.

I have personally seen people average all the way down, with three or four or five new buy orders. They lost their shirts on stocks like Nortel and some of the Internet high-flyers.

As I state in our section on Tips of the Insiders, I do not support the concept of averaging down. In fact, if you abide by the methodology of Limiting Losses that we describe later in Chapter Six, you will not be in a position where you would need to average down.

Bad 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. In addition, it magnifies your losses if the stock keeps dropping. 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.

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