Price averaging is the act of extending an existing position in a stock by buying or shorting additional shares at a different price than the current entry price of the position, which alters the average price of the position as a whole.
For example, suppose that an investor buys 1 share of company A at $2 per share. The average price of the position is now $2 per share. Now imagine that the price of the stock falls to $1 per share and the investor purchases 1 additional share at the new price. The average price of the stocks in the position is now (2+1)/2, or $1.5 per share.
While the current absolute unrealized loss in the position remains the same at $1, the average loss per share is reduced to $0.5.
Averaging Down and Averaging Up
The terms ‘averaging down’ and ‘averaging up’ refer to the two possible directions in which price averaging can take place. Averaging down occurs when the investor purchases additional shares at a lower price, which lowers the overall average share price of the position. Averaging up occurs when the investors shorts additional shares at a higher price, which increases the overall average share price of the position.
Price Averaging in Trading
While the average price of the shares in a position are not an ideal metric for the evaluation of a position’s profitability, the value of the act of price averaging in itself depends on the circumstances.
If an investor is confident that shares in company A will soon rise from $2 to $3 per share, then a short term drop to $1 per share is merely an opportunity to buy further shares and improve the overall profitability of the position as it goes to $3 per share.
On the other hand, price averaging can act as a cover for the dangerous gamble of ‘doubling down’. Doubling down on a trade turned bad is an emotional response to a loss, and can quickly see that loss magnified as increasing amounts of money are added to a losing position in the hopes that the price will turn around and erase the current losses.
Price averaging is an inherent consequence of adding to an existing position, but the changing average price does not magically alter the current profitability of an existing position. Price averaging can be a deceptive trap, where the emotional urge to double down on a losing position can be bolstered by the ameliorating average price of the shares in that position.