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Educational Article

Dollar Cost Averaging

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By David Popper

One of the oldest and most highly recommended methods of investing espoused by investment professionals to the public is the concept of dollar cost averaging. The idea behind dollar cost averaging is that from their view, it is impossible to time the market. Therefore, it makes sense not to become fully invested all at once, but rather to put in a fixed amount monthly. When the market is low, you will buy more shares and when the market is higher, you will buy less shares. In this way, an investor can take advantage of market volatility without having even the faintest understanding of technical analysis. Though long-term "buy and hold" is not my cup of tea, I believe that lessons can be learned from our mutual fund long-term holding friends.

When one buys mutual funds through the dollar cost averaging method, two safety features become built into the investment plan. The first is diversity of holdings. Obviously, the mutual fund holder will not be exposed to the risks or rewards of a highly concentrated tech portfolio. The fund holder will be less lucrative in the good times but it will be much safer in the poor times. The second safety feature is diversity of timing. If one bought a slate of mutual funds in March 2000, that investor would be in trouble. Those same funds invested incrementally over the next 12 months would have yielded a substantially better result.

What if traders could employ these two safety features and still obtain excellent returns? It only makes sense to employ as many safety features into a trading method as is possible, while still achieving a trader's goal. As a matter of fact, most serious books on trading spend most of the time on discipline and safety. Without trading disciplines that protect a trader during a downturn, an account will surely blow up. So, back to the question, how can a trader employ these two safety features? I will try to outline a plan below:

1. TRADE ONLY BASKETS OF STOCKS WHICH WILL ALLOW COVERED CALLS WRITTEN AGAINST THE POSITION. There is safety in diversity. For example, one could trade the QQQ (NASDAQ:QQQ). The QQQ is a weighted composite of the top 100 NASDAQ stocks, excluding financial stocks. It covers a variety of sectors. Therefore, when one stock falls out of bed, the QQQ doesn't move much. There is the protection of diversity. There are other trading vehicles. Currently, many are products developed by Merrill Lynch and are listed on the American Stock exchange's website. These products allow you to be represented in a sector without being responsible for picking an individual stock. The holders typically include twenty or more positions which represent stocks in the sector. You can write covered calls against the QQQ or Holders. You can also write covered calls against certain index funds representing the S&P 500.

2. DOLLAR COST AVERAGE YOUR PURCHASES AND WRITE CALLS OUT 3 MONTHS. No matter what you may have purchased over the past year, unless you are an excellent daytrader with the time to watch the market on a tick by tick basis, chances are your positions are underwater. If you were to divide your assets into four equal parts and begin to buy the QQQ and write a covered call out 3 months, your premium would be between 12 to 15%. You would only have 25% of your portfolio at risk. If the market dropped, you would have serious protection. If the market ran up, so be it. The next month, you would employ another 25% of your assets. This would be an entirely different play, even if still using the QQQ because the entry point into the stock and the strike price of the option would be very different. Now you have 50% of your assets employed. On the third month, you would again repeat the process and would have 75% of your assets in the market. At the end of the third month, the original options on the first 25% position would expire and so that same 25% would be redeployed and so forth. After three months, there would be an option cycle expiring every month and thus a monthly premium would be captured. You would be able to stay in sync with the market because you are never fully invested and so you always have some flexibility. You may have noticed that the final 25% was never discussed. In my opinion, there should always be some cash in a portfolio for flexibility and for emergencies. That 25% would stay in cash in my portfolio.

In real life, how would this work? For simplicity's sake, let's use $100,000. On month one, if $25,000 of QQQ was purchased, and calls were written for the July expiration, I could expect to recover a premium of $3000 to $3750. At May expiration, I would employ the next $25,000 and write August calls and receive a similar premium. At the June expiration, I would write the September calls. At the July expiration, the first calls would have expired and I can deploy that 25%. After the initial startup, I would be receiving between $3000 and $3750 monthly, while keeping $25,000 in reserve. True if the market implodes, even this method will not save you. Even mutual funds are down now. You will be hurt less, however, while still drawing a nice monthly premium.


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