The general advice that most traders would give you is that in short term trading, averaging is quite bad for your trading health. What is averaging. Let us assume that you bought Reliance Industries (RIL) at Rs.1250/-. You have set a stop loss at Rs.1230. When the stock comes down to 1235 you have 3 choices in front of you. First, you can wait till the stock touches Rs.1230 at which price the stop loss automatically gets triggered. Secondly, you can take a call that a call that RIL is weak in trade and decide to terminate the order at 1235, reducing your loss by Rs.5. The third option is to cancel the stop loss and put a buy order at Rs.1230 to double your average position and bring down your average cost to Rs.1240. The third option is what averaging is all about. That sounds quite logical but then it is not as simple as that. There a lot more nuances to averaging your position. Before averaging your position, here are some basic questions you must ask yourself.
Question 1: Has the stock gone into an intermediate downtrend?
For any intraday trader, trend is their friend and they must try to stay close to the trend as possible. Intraday traders rarely trade against the trend nor do they try to outsmart the market. The key question to ask is whether the stock has gone into an intermediate downtrend. This has nothing to do with the quality of the stock or the quality of the management. Both these may be favourable and yet averaging may be the wrong choice if the stock is going into an intermediate downtrend. Take the case of L&T in 2011. The capital cycle was turning down and investors realized that L&T will not be able to maintain its growth and margins to justify its valuations. The stock lost more than 50% over the next couple of years. When the underlying trend shifts, there is no point in averaging. Intermediate trend is also impacted by major shifts. It happened to IT and Pharma when their global models came under question. The same happened to auto stocks in 2018 when demand compressed and funding was tight. In such cases, there is no point in averaging because you are playing the wrong trend. However, a stock like auto or pharma above becomes a sell-on-rises stock. In such cases, if you are short and the stock price goes up, you can consider averaging your position.
Question 2: Will averaging skew my portfolio mix?
This has less to do with the fundamental shifts in the stock and more to do with your own portfolio mix. If you have a 20% exposure to the banking sector and that is also your maximum exposure, then you must be careful about averaging as it will unnecessarily expose you to higher banking risk. This must be extended to themes also. When you are long on NBFCs, it is a rate sensitive stock. Averaging even auto or realty stocks would mean that you exposing yourself more to these rate sensitives. In such cases, averaging is like committing the same mistake twice.
Question 3: Should I average when macro risks are high?
The answer is clearly, you must not. Macro risks come in a variety of forms like higher inflation, interest rate hike, Fed rate hike, higher fiscal deficit, failure of monsoon, weak rupee etc. These macro risks make your positions volatile and that is a risk. When macro risks are high, it is best to stay light in the market and avoid averaging either on the long side or the short side.
Answer: You can average constructively too
The idea is to use averaging constructively and to your long-term benefit. There are stocks that have a lot of momentum in their favour. You will also be in doubt as to what is the right price to buy these stocks. One of the solutions is to average stocks each time it gives a correction. This will ensure that the long-term average cost of acquisition of the stock is at the lower end. Averaging is a great idea if used carefully and with the necessarily protection. As long as momentum is still on your side, you can surely look to average but it is just that you must not go overboard.