Dollar Cost Averaging: Split Trades to Benefit from Volatility!

What is Dollar Cost Averaging?

Dollar cost averaging is a trading strategy that is mostly used when purchasing mutual funds or stocks. The trader splits the trades by purchasing shares of equal amounts over a certain period of time, and at steady intervals.

For instance, if you want to buy company X’s shares that are worth $20,000, you can choose to buy stocks worth $5,000 on the first day of each quarter in a year.

Yes, this is a profitable strategy, especially for those who invest in the long run. But there is some benefit for day traders as well.

How traders use the DCA

Traders use dollar cost averaging to even out their purchases over time and to ensure that they are not trading at high price points. The strategy is especially beneficial in bear markets since you will buy the dips.

Discipline and consistency are crucial for the success of this model. Whether the market is going up or down, you need to consistent on when, what, and how much you trade.

Example & Calculations of Dollar Cost Averaging

To understand the benefits of this strategy to a trader, it is useful to compare two scenarios; one where you purchase all the shares at once, and another where you buy them in bits.

In the first scenario, let’s assume that you have $2,000 that you have set aside to purchase the shares of company X. The firm’s shares have a market price of $10. At that rate, you will net 200 shares.

Buy Shares using the DCA

Now let’s create a second scenario that involves dollar cost averaging. In this setup, we will assume that you will split the $2,000 into 4 equal parts. This means that you will purchase shares worth $500 each month, for 4 consistent months.

In a typical market, the stock price will vary from time to time. The table below shows the amount you will spend on each month, the prevailing share price, and the resultant number of shares.

MonthAmount usedStock pricePurchased shares
1$500$1050
2$500$1533.33
3$500$5100
4$500$1050
Total number of purchased shares: 233.33

If you compare both scenarios, you will realize that you will acquire 33.33 more shares when using the dollar cost averaging model than when buying the stocks in lump sum.

The average stock price will be $10. To get that figure, add the different stock prices and divide by the number of months {($10 + $15 + $5 + $10)/ 4 months)} = $10.

This figure is similar to the stock price in the lump-sum scenario. Depending on the volatility of the market, you tend to get more value for your money with dollar cost averaging.

Dollar cost averaging strategies

Like any other trading approach, the DCA requires effective strategies. Here are some of the strategies you should use to ensure that dollar cost averaging works to your advantage.

Conduct detailed research

List the companies that you are interested in. Only pick firms that have a significant growth potential. To understand what and why you are buying, analyze the company’s financials, analysts’ reports, and the annual reports.

Ideally, if you are using dollar cost averaging to invest for the long-term, you need to do substantial research on the company. Start with the industry you are investing in. Some of the most popular industries are technology, consumer staples, consumer discretionary, and energy.

Second, use a screener to identify companies that meet your preferred criteria. Using a screener will save you substantial amount of time.

Third, do more research about the company. In this, look at its revenue and profitability growth, moat in its industry, dividends and buybacks

Finally, assess whether the stock is undervalued and then establish the potential catalysts that will push it higher.

Set aside the amount you intend to trade

Use an amount that will not hurt your bank account. Depending on the intervals you plan on using for the DCA setup, ensure that the funds are available.

A good knowledge of money management tactics and knowing what your risk/reward ratio is much important for this point.

Diversification

This is an effective risk management tactic. Consider buying stocks of different companies and from different sectors.

This strategy can also be used by day traders in a separate account in which they adopt some medium/long-term strategies. Just to mitigate the risks of their daily activities.

This is not easy, since the type of analysis is completely different from what they are used to, but it is still a viable option that should not be overlooked.

Be consistent

Dollar cost averaging operates on discipline and consistency. As such, don’t wait for the stock price to reach a certain level for you to purchase the shares. Besides, the amount you set aside should not vary.

Purchase the shares on the same day, for the same amount, and for the same company. Even if the market falls significantly, hold on to your belief that your choice is a profitable share.

Dollar Cost Averaging vs timing the market

Dollar Cost Averaging is often confused with the concept of timing the market. The two are significantly different. As explained above, DCA is the process of buying stocks and other assets in tranches over a long period of time.

Timing the market, on the other hand, is the process where a trader attempts to predict what will happen in a certain period. For example, if a stock moves from $20 to $30 within a short period, the trader can short it since they expect that it will resume the downward trend.

Similarly, a trader who is timing the market can rush to buy a stock that has crashed in a certain period.

Related » Time in the Market V. Timing the Market

Benefits and Disadvantages of Dollar Cost Averaging

Like any other trading strategy, dollar cost averaging has its pros and cons.

Benefits

  • It is a beneficial trading approach in a volatile market or under uncertain market conditions.
  • It is a useful approach if you don’t have a lump sum to trade with at once.
  • This strategy helps a trader make decisions without involving emotions: whether the stock price fluctuates in between your trades, you know when and how much shares you will purchase.
  • Avoids mistiming the market

Disadvantages

  • For dividend stocks, you may end up getting a lesser income.
  • The price of most stocks tend to increase over time.
  • It is not ideal if you intend to trade on a short term basis.

Risks of DCA

DCA comes with two key risks. First, there is the risk that the stock will start rising after you make your first purchase. For example, assume that you have $10,000 to spend and the stock is trading at $10.

In this case, you could make the first purchase when the stock is at $10 and hope to make the next purchases when it drops to $9, $8, and $7. However, at times, the stock could rise without retesting the other levels.

While your first tranche will be profitable, you will have lost an opportunity with the rest.

Second, at times, a stock may continue dropping after you make your purchases. Using the above example, the stock could drop to as low as $2, meaning that all your purchases will be at a loss. And in this case, it could take a long time before it stages a recovery.

Final Thoughts

Dollar cost averaging involves splitting a trade, such that you purchase stocks or mutual funds at equal amounts and at equal intervals. With this strategy, the aim is to benefit from a volatile market, avoid mistiming the market, and gain from buying the dip.

External Useful Resources

  • How To Invest with Dollar Cost Averaging - Forbes
  • Don’t Get Caught In the Dollar Cost Averaging Trap! - RuleOneInvesting

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