Friday, October 26, 2012

Averaging Down in a Position

When given the opportunity to average down in a position that I own and want more of I'll normally take the chance when it's the best opportunity available. Averaging down gives you a chance to lower your cost basis in a company that you have already deemed investment worthy.

Most often the chance to average down comes after some negative news for the company, whether it's a macro-economic issue or company specific issue, such as a recent earnings miss.  Averaging down in a position does require monitoring.  You need to know if something has changed fundamentally with the company or if it's just market noise currently voting against the company.  This is why it's important to devote some time each week to every one of your holdings to get the latest news in an attempt to discern if the price movement is justified.  Once I feel comfortable that nothing of note has changed, then it's time to purchase shares to average your cost basis down.

One of the biggest things that I struggle with as far as averaging down is what price to aim for.  Typically I try and get a 2.5% to 5% pullback before purchasing more shares, however sometimes you just don't get the chance for that big of a pullback.  I know there's been a few times where I missed the opportunity to lower my cost basis because I was looking for a certain percentage lower and that price just narrowly missed.  I've also thought of aiming for a 1% decrease in the average cost basis once the new shares are added.  I continue to go back and forth on this issue for what method to use, although I guess it should be more company specific because some companies have much larger swings than others.

What are your thoughts?  Do you prefer to have a target percentage decrease from the original cost basis or target a decrease in the total cost basis with the new shares purchased or buy if it's the best opportunity even if it's just a little less than your purchase price?

8 comments:

  1. I don't have any specific criteria for averaging down. Basically, if the opportunity to average down on a stock is more attractive than the other opportunities I'm considering, then I will probably do it, without much regard for the exact percentage by which I'll lower my cost basis.

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    1. Thats about how i work it but now that we're getting a pullback its made me wonder how to approach averaging down.

      Thanks for stopping by!

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  2. You have to be disiplined and take all emotion out for this strategy to work for sure. It's a tough one in my experience.

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    1. The part I get hung up on is whether I should aim for a certain decrease in price before I purchase. Although I guess it's really company specific because some company's share price just aren't nearly as volatile.

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  3. Interesting. I've never even thought about specific % decreases for averaging down. I have thought of specific prices and yields however.

    Normally it works like this for me: Do I want to own this company? Is the price reasonable? Does it fit my allocations? Is there something else that has a better valuation right now? When I'm done answering these questions there are usually 1-3 companies to choose from.

    I like to average down, but I try not to even worry about it. I think the stock market will trend higher over time. We won't always be able to average down. I find that it's more difficult to add to a position that has increased in price. Averaging up is the hard part for me psychologically. I want to buy more KO, but the price has gone up since I bought it 18 months ago. I'm struggling with this right now!

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    1. I'm the same way with KO. I've been wanting to add more but it's hard to justify averaging up. I need to update my stock analysis spreadsheet to find out what the new fair value price is.

      I usually go through the same steps as you for adding to a position and ask myself the same questions. But I've had a few times where I've missed out on adding to a position because the price/yield targets just barely missed. I figured it was something worth throwing out in the blogosphere to see what some of my fellow DG investors think about the situation.

      Thanks for stopping by!

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  4. One way to average down is write naked puts on the stock you want to own. Admittedly the premiums generally stink on the very buy-and-hold DGI stocks we want. If you keep writing puts, it is like extra dividends. I own long positions in KO, AFL, COP, F, MCD yet also have active puts written that provide me immediate income or, if the strike price hits, reduction my average share price.

    As a specific example, my current average cost of F is $15.61. I'd like to buy more as the stock is just hovering around $15.20. At what price should I buy? Heck, how about 2-3% below the current price? 5% below my average price? Should I wait for a pullback? Should I place a limit order at $14.90?

    My solution is to write puts. In this specific case, I wrote $15 puts -- on 3/18 expiring 4/19 and again on 3/26 expiring 4/11 puts. If F drops to $15 and I get put the shares, my break even price is $14.85 and $14.88 which, based on my option price, will be 2.65% and 3.3% below the price of the stock on the moment I wrote the puts. These buy prices are also about 5% below my current average share price.

    What happens if F goes up? Then the options expire worthless and I will have earned 11.75% annually on the 4/19 puts and 18.94% annually on the 4/11 puts. Clearly I will also have missed the current and future appreciation in F with the lower cost basis. Yet if I had placed a limit order at $14.90 and the stock went up so the order never hit, I would have missed both the income AND the stock appreciation.

    I also do this with BRK.B -- the premiums REALLY stink here but my three puts are paying 6.3%, 9.8%, and 13.5% annually. I want more BRK and I'm getting paid to wait; the risk is either 1) the stock will "run away" and I'll be left with my ~10% annualized "dividend" on BRK (which, of course, pays no dividend at all.), or 2) the stock will tank and I'll lower my average BRK.B cost by a slim 0.4%.

    Best of luck investing.

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    1. Dave,

      I use puts as well although I haven't been as active because a lot of the premium/strike combos haven't been all that compelling to me. Although admittedly I haven't been actively seeking them out recently. I do like selling puts though when you can get a good return either way it works out by added income or lower cost basis. It's a fairly simple strategy and I think more people would employ it if they understood it, but a lot of people hear options and think it's some crazy derivative that is way too risky.

      Thanks for stopping by!

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