I recently wrote a piece about stop losses and how many retail traders/investors prefer to take the risk and trade without them. At the time, I mentioned the psychology of hope and conviction in share price recovery, holding on to a losing position “because it might bounce back”. This week I develop on the latter, discussing “averaging down” as a strategy.

Because if you really believe that a loss-making position can get back to break-even, then you are stating your belief in a share price recovery. But why settle for simply breaking even? Why not profit from your conviction in that share price recovery? After all, we buy low to sell high. And if you aren’t convinced, only thinking that it might recover, why are you still in the position? Why tie up capital that could be working elsewhere, generating positive returns?

Remember, when holding out for a return to break-even, a 10% decline can only be offset by an 11.11% recovery, because the starting point now is lower. A 20% fall requires a 25% rally. A 30% drop can only be neutralised by a 42.85% rise. A 40% fall? 66.66%! And so on, and that’s just to break even. A lot of hard work, just to get back to zero.

If you really do believe that the share price will recover to your entry price, why not buy more shares at this new depressed price or when it starts to rebound? Because if the share price does bounce back, not only would the original position be back to break-even, the new position will have appreciated too, meaning a profit, which was your goal originally.

Buying more shares at a lower price (or higher if you are short-selling the shares, hoping for a decline) serves to reduce your average entry price, in turn reducing the share price recovery required for you to get back to break-even. This is also known as “averaging down”.

Say you bought 10,000 shares at 100p (a £10,000 trade) and the share price fell by 10% to 90p. Your position is now worth £9,000. You could wait for the 11.11% recovery required for your £9,000 to become £10,000 again. Or, if you really believe the shares will bounce, you could buy more shares in order to actually benefit.

Another 1,000 shares bought at 90p (another £900 trade) and a share price rally to 100p means the original trade hits break-even and the new trade generates a £100 profit (1,000 shares x 10p). If the shares keep rising, both positions become profitable and you can think about using stop losses to protect the profits.

Alternatively, the new trade can be used to average down your entry price across the two positions. This allows you to exit both positions at a lower price than your original 100p entry. Now that you own 11,000 shares (10,000 + 1,000) purchased for £10,900 (£10,000 + £900) your average entry price becomes 99.1p. If the shares do rally, you could close both positions almost a penny earlier, thus requiring only a 10.1% rally, instead of the original 11.1%.

If you’d bought another 2,000 shares at 90p, and the price hit 100p you could take a £200 profit at 100p or exit both positions break-even at 98.3p, requiring only a 9.3% rally; With 3,000 shares, its either a £300 profit or break-even at 97.7p (+8.5%); 4,000 shares, £400 profit or 97.1p breakeven (+7.9%); 5,000 shares, £500 profit or break-even at 96.7p (7.4%). The more shares you buy at the new lower price, averaging down, the less of a share price rally required to get you back to break-even.

The shares could, of course, take another leg lower. But that was always a risk. Just because you are “hoping” for a recovery, doesn’t mean it’ll happen. Hope is an optimistic state of mind not a strategic conviction. And stop-losses (“normal”, or “guaranteed”) are always available to protect from bigger losses.

What’s more, if the shares do rally, “trailing stops” can helpfully follow the share price higher meaning that, whatever happens, the profits on the new trade are protected whilst simultaneously ensuring that any loss taken on the original trade is now smaller.

All thanks to averaging down (and stop losses). As they say, sometimes less is more.

Mike van Dulken, Head of Research, 16 Nov 2018