One of the most common questions asked of me is: “How do I get started if I don’t have a lot of money to invest?” Another is “What is the most conservative way to start selling covered calls?” These questions evoke the same sentiments I had when I first began educating myself in this strategy:
- Fear of the unknown
- Excitement for the possibilities
- Preservation of capital
One of the techniques that conservative investors can employ as we build our covered call portfolio is dollar-cost averaging. This is a technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. The benefit of dollar cost averaging (as opposed to a lump sum investment) is that over time, more shares can be purchased at a lower price. For investors who are developing a portfolio large enough to then start selling covered calls this is an approach that should be considered.
Let’s say we have $1200 to invest. Instead of investing it all at one time, we could invest $100 on the 1st of every month (or whatever date you determine) for twelve months.
Does it go by any other names?
Dollar-cost averaging is also called DCA and Constant Dollar Plan in the U.S. and Pound-Cost Averaging in the U.K. and the currency neutral term of Cost Average Effect.
The Three Parameters:
- The fixed amount of money- in the above example, it’s $100.
- The investment frequency- in the above example, it’s once a month.
- Time horizon- in the above example, it’s one year.
How it works:
The reason we dollar cost average into a security is to ultimately own more shares at a lower price, which protects us from losing maximum capital if there is price depreciation. For example, assume you have $1200 dollars to invest in stock XYZ, and decide to dollar cost average your investment by purchasing $100 of XYZ every month for a year, regardless of what price XYZ is trading at in any particular month. Assume further that the price of XYZ depreciates from $10 per share in January to $5 per in December, as depicted below:
- January: $10 per share buys 10 shares
- February: $9 per share buys 11 shares
- March: $7 per share buys 14 shares
- April: $5 per share buys 20 shares
- May: $6 per share buys 17 shares
- June: $9 per share buys 11 shares
- July: $10 per share buys 10 shares
- August: $11 per share buys 9 shares
- September: $12 per share buys 8 shares
- October: $10 per share buys 10 shares
- September: $9 per share buys 11 shares
- October: $7 per share buys 14 shares
- November: $6 per share buys 17 shares
- December: $5 per share buys 20 shares
Over this 1-year time frame, we purchased 182 shares. Had we invested the entire $1200 in January when XYZ was trading at $10 per share, we would have purchased only 120 shares. Yes, we still lost money, but not as much had we not dollar-cost averaged our investments:
- Money lost with a 1-time investment: $600 (120 shares x $5) = $600 remains from $1200 investment
- Money lost with dollar-cost averaging : $290 (182 shares x $5) = $910 left from $1200 investment
Disadvantages and criticisms:
Before investing our hard-earned money, it is critical to also understand the criticisms, both valid and invalid, commonly associated with dollar cost averaging, which include the following:
1- It is a marketing gimmick that lulls worried investors into investing more than they normally would have. I think this criticism was created by pundits who suggest that fear is somehow a positive. The market historically goes up, and in my view, no one has developed the skill to perfectly time the market, as there are way too many parameters that influence market direction. How can a computer software system or a great economic mind quantify market psychology, or ever-changing news or global influences? Even Warren Buffett lost a tremendous amount of wealth during the recession of 2008. If we can agree that accurate market timing is not possible, and that we will only invest what we can afford, dollar cost averaging can be a great strategy for most neophyte and conservative investors.
2- Dollar cost averaging ignores transaction fees: This is a valid concern, but one that can be easily avoided by using the appropriate investment vehicles. In our hypothetical example with stock XYZ, had we paid a $25 transaction commission fee for each of our monthly purchases, our bottom line would have been dramatically negatively impacted. That is why dollar cost averaging works best with mutual funds or ETFs when using extremely inexpensive online discount brokers, especially when investing modest amounts of money. A typical no-load index mutual fund can have an expense ratio (the cost to invest in a mutual fund, determined by dividing a fund’s operating expenses by the average dollar value of its assets under management) of 20 basis points. This means that for a $100 investment, you would pay only 20 cents, and not the $10 to $25 fee typically charged by discount brokers to execute an individual stock purchase. When considering which underlying securities to purchase in contemplation of selling covered calls, dollar cost averaging into ETFs through an inexpensive (but quality) online discount broker, or into a no-load index fund, can prove to be a conservative cost effective strategy, and one particularly useful to the neophyte covered call writer, as noted above. In short, by investing with the appropriate investment vehicles and using a cost-efficient broker, transaction fees can become a non-event. Note: There are no transaction fees when you buy Schwab branded ETFs online, some of which are optionable. Some Schwab ETFs have a lower expense ratio than Vanguard, iShares, or SPDRs.
3- We will miss out on profits if the market appreciates dramatically from the time of the initial investment: Once again, this is a valid point. The hypothetical dollar cost averaging example detailed above (in stock XYZ) is a negative scenario, or one that we need to protect ourselves from. In that example, had the market took off like a rocket ship, we would have ended up buying shares at higher and higher prices. This potential drawback is the price we pay for risk management. Most of us who use the dollar cost averaging technique cannot afford to lose large amounts of money, and downside protection from large losses is precisely what this strategy offers. Although this downside protection comes at the potential cost of missing gains in an uptrending market, we accept that cost and sleep better at night.
It pays to exercise caution when it comes to investing our hard-earned money. For those just starting out in the stock market, or for conservative investors in general, dollar cost averaging into a no-load index fund with a low expense ratio, or an ETF with a great online discount broker, may be a sensible choice. Many mutual funds also have automatic investment plans that allow you to invest a fixed amount automatically each month. Many times, the initial minimum investment needed to get started is much lower when automatic investing is set up. This technique will allow us to build a large enough portfolio of securities to then start selling covered calls while maintaining proper diversification. One excellent starting point to look for low expense ratio index funds is:
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Here is a summary of this week’s mixed economic reports:
- The Conference Board’s leading economic indicators rose 0.2% in September for the fifth straight increase but the lowest since April
- The latest Beige Book reflected a slight increase in economic activity for September and week 1 of October
- Consumer prices rose 0.3% in September meeting analyst expectations and suggesting that inflation is not a concern
- Core producer prices rose by 0.2%
- Sales of existing homes fell by 3.0% in September but…
- New residential construction skyrocketed by 15% in September mainly from a surge in multi-family units
For the week, the S&P 500 rose by 1.1% for a year-to-date return of 0.1% including dividends.
A 3-month chart of the S&P 500 is showing signs of a possible breakout to the upside:
We see a slight breakout from the trading range but on less than spectacular volume. The chart is encouraging but let’s not breakout the champagne just yet.
IBD: Confirmed uptrend
BCI: Cautiously bullish, fully invested and favoring in-the-money strikes.
Thanks again for your incredible response to my new book. I hope you enjoy it and benefit from it.
Much success to all,
Alan ([email protected])