Dollar Cost Averaging Plan & Trading Example
What is Dollar Cost Averaging (DCA)
Dollar cost averaging is a trading methodology where an investor purchases a fixed dollar amount of a security, over regular intervals (e.g., monthly, quarterly). This way the investor avoids the risks associated with taking their entire position at once. Dollar cost averaging plans work best with a longer investment time horizon. This is because the stock will have greater price fluctuations over a longer time frame, which will provide a number of opportunities for an investor to add to their position. If the market is in a strong bull market, a dollar cost averaging plan will not beat a lump sum strategy. But in the event the market has a pull back, like the credit crisis of '08, an investor will be able to avoid significance lossess, as a result of buying the security as it pullbacks.
Creating a Dollar Cost Average Plan
There are a number of steps a trader must take in order to develop a sound dollar cost averaging plan.
- Assess if the market is in a strong downtrend (if so postpone the DCA)
- Identify a sector that has strong growth potential
- Identify the strongest stock within that sector
- Determine how much money you are willing to invest
- Figure out the length of the investment horizon and the purchasing intervals
- Lastly determine the price and or time target for exiting the position
Dollar Cost Averaging Trading Example
The below chart is from Las Vegas Sands Corporation (LVS) from early '05 through the end of '07. Notice how LVS was in a consolidation phase with a downward bias during '05. This stock was a prime candiate for dollar cost averaging as a trader would be unsure of how low LVS could go in the near term, but was certain that the stock will be higher over the next 2-3 years.