When I last wrote about “Averaging In” the UK 100 was in the midst of a 16% Aug-Dec decline towards Christmas lows. This time, I hope the current 4.5% sell-off is a mere correction within 2019’s recovery rally (15% so far). So I hope we’re close to the bottom. Because we all want to buy at the lows, to profit from the next up-move.

What’s this about Joe? Let’s say he has a share position which is in the red. But he honestly believes it will recover to break-even, perhaps even its once profitable situation. He’d be right to hold on, if that’s what he really believes.

On the flip-side, if he’s only holding on because it might recover, he has to agree it might also get worse. Prepared to take that risk? He could say “I’ve already lost 50%, who cares?” I counter this with “If not convinced, why keep the position? Why not close it, preserve the remaining 50% and put it to better work elsewhere?”

Furthermore, if he believes that strongly in a recovery, he must also acknowledge that declines are only offset by bigger rises. Because you’re starting from a lower base. A 10% fall requires an 11% recovery; 20% fall, 25% rise; 30% drop, 42% rally; 40% slide, 66% climb. And so on. Losing positions must work harder to reach break-even, never mind profit.

So if Joe believes in the recovery, why not buy more at this lower price? Not only would it capture any recovery in full, itwould also lower his average entry price. This means he could exit his positions at breakeven even earlier than the original entry price.

Example: If you buy 10,000 shares at 100p (a £10,000 trade) and the shares fall by 30%, you now own 10,000 shares worth 70p or £7000. To get back to breakeven the shares now need to rally 43% (not 30%) to get back to 100p.

You could, however, buy another 5,000 shares at 70p (another £3,500 trade). If the shares do rally, you then have 3 options to choose from regarding your new bigger position;

1. Close out at your new breakeven of 90p (£13,500/15,000 shares). 
2. Wait for your original 100p entry price and book a handsome £1,500 profit (15,000 shares * (100-90p)).
3. If the shares rally beyond 100p, your old and new shares would be in profit. You could even close a portion at 90p and allow the remaining shares to profit from any rally higher.

This is commonly used by traders to profit from belief in share price recovery. It reduces the distance shares need to rally in order to get back to break-even, or even into profit.

This does involve taking more risk, putting more money into the shares. But if you’re hanging on to a losing position, adamant about a recovery, what are you worried about? Unless you’re not that convinced, merely hoping. If that’s the case, may I direct you back to paragraph 3.

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Have a nice weekend.

Mike van Dulken, Head of Research, 10 May 2019