Why Great Traders Average Up, Not Down
Do you buy a stock if stock price goes down?
If you walked into a department store and saw a fabulous product marked down from Rs.375 to Rs.199, you might be tempted to buy it.
If you walked into a department store and saw a fabulous product marked down from Rs.375 to Rs.199, you might be tempted to buy it.
And if you saw it priced at Rs.99, you might feel you were getting an irresistible bargain. Perhaps you are.
But stocks are not such product.
A good trader doesn't average down - that is, buy more - as a stock plummets in price (although there is one exception to this rule, as I'll explain in a moment).
A good trader doesn't average down - that is, buy more - as a stock plummets in price (although there is one exception to this rule, as I'll explain in a moment).
Whenever you see a stock that is plunging in a flat or rising market, it's a warning sign that something is wrong.
Why You Shouldn't Try to Catch a Falling Knife
Why You Shouldn't Try to Catch a Falling Knife
You may not know what the problem is that is causing the stock to fall.
- It could be that sales are down.
- Perhaps the company has lost a major customer.
- Expenses could be rising unexpectedly.
- A new competitor has emerged and is taking market share, or driving down profit margins.
You
may not know the reason for sure until the company makes some kind of
public announcement. But by then, the stock could be substantially
lower. Why do shares decline before any corporate announcement? Because
bad news often filters into the market through customers, suppliers,
employees, competitors, or analysts.
As a rule, a stock taking a swan-dive in a rising market is no blue light special. Averaging down on a losing position has the potential to leave a short-term trader throwing good money after bad.
Ask any shareholder of Satyam, Rajesh Exports, or Suzlon
However, there's an exception to this rule...
The One Time When You Should "Average Up"
The
exception is when a company reports superb results - outstanding growth
in both sales and earnings - but the broader market is declining.
When
investors get scared or nervous and the market averages plunge - taking
shares of healthy, growing companies down, too - that's the time to buy
these companies on price weakness.
The Best Way to "Average Up"
This may go against every frugal bone in your body. After all, averaging up means increasing your average cost per share.
But it may also mean that you have a greater amount of money invested - and your final profits should be larger.
On
your initial purchase, a good rule of thumb is to put in half the
amount of money you intend to invest. After the stock rises 5%, put in
another 25%. Assuming it rises another 5% - or approximately 10% from
your initial entry point - invest the final 25%. Then run your trailing
stop based on your average purchase price.
The
advantage of this system is that you have less money invested in stocks
that don't pan out. And more money invested in those that do.
Over time, this will be a big factor in determining your success as a trader.
Good investing,
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