When I typed ‘dollar cost averaging’ into Google, the search engine returned 493,000 results which ranged from “Dollar Cost Averaging Pays’ to ‘Dollar Cost Averaging’s not all it’s cracked up to be’. So which is it?
By purchasing a fixed dollar amount of stock at regular intervals, the expectation is that a trader will never suffer from buying all at once at peaks, at the expense of never gaining from buying all at once at the absolute bottom either. The approach can be successful when trading retirement accounts or indeed contributing to Employee Stock Purchase Plans. Both are implicitly designed for non-sophisticated investors who have little interest in actively monitoring their virtual portfolios. Dollar cost averaging can also be commission intensive and capital intensive. That’s where options offer a much more attractive solution to dollar cost averaging.
Rather than spend money at regular intervals to purchase stocks, options afford us the opportunity to get paid at regular intervals to agree to purchase a stock. Let’s take a look at how to implement this strategy first and then look at some of its benefits.
We’ll assume that I find a company that I believe has reasonable fundamentals but I am not particularly comfortable about buying it at its current price level. We will use Manitowac (MTW) as an example. The stock is trading at $49.09 which is perilously close to its recent 52-wk high of $51.49 and still a few dollars above its 20-day EMA at $46.84. So technically it’s not screaming a buy but fundamentally I might be attracted to its 32% return on equity, its Price/Sales figure of 0.64 and its PEG ratio of 0.84 and its projected earnings growth of 29% next year. Rather than start to buy at its current level I can agree to get paid to buy the stock near its 20-day EMA level, where it has bounced numerous times over the past 6 weeks. The way to do this is via a bull put spread.
A January bull put spread strike 47.50/42.50 offers $0.95 of premium for a period of 19 days, equating to a reasonable 23% return on risk for the timeframe. If the stock stays above the $47.50 level, the short puts will expire worthless, but if it drops below that level the trader is required to purchase the stock for $47.50 per share minus the $0.95 credit received from entering the bull put i.e. $46.55 (just under the 20-day EMA at $46.84). But what if the stock were to continue falling?
Instead of committing all bull put spread contracts to the single spread in January, several spreads can be entered using a laddered approach to strike prices. For example, the February 45/40 bull put spread offers $1.00 credit while the lower strike 40/35 bull put spread in June offers another $1.00. Even if the only action taken by the trader was to enter these trades (we will note that long put purchases should be made when convinced of a downtrend) and assuming the stock declined all the way to its 200-day MA which has consistently held as support all year, currently residing at $39.93, the trader would be required to take stock ownership at regular intervals at $47.50, $45 and $40. We must factor in that the trader keeps all the option credits too, so the actual cost basis of ownership would reduce to $46.55, $44 and $39. Hence the average cost basis would be $43.19.
If we contrast this approach with an outright stock purchase or a regular dollar cost average purchase, it proves more attractive. By making an outright purchase at the stock’s current level, a decline to $39.93 represents close to a 20% correction, and the trader would suffer during the entire decline (again assuming worst-case, no puts are purchased). By dollar-cost averaging in buying stock at the stock’s current level and again at its 20-day EMA and 200-day MA, the average cost basis would be $45.28, higher than previously calculated using the bull put spread methodology.
The other advantage to the bull put spread method is that you as the trader are getting paid to participate in the stock market! How much better it feels to know the credit from the bull put spread helps pay those commissions costs rather than having to dig into your own pockets to pay the charges. If you were considering buying stock on margin also, note that interest charges are not an issue when you enter bull put spreads again because the margin requirement for the bull put spread is simply the risk of the spread.
All in all, this approach proves much more attractive over time compared to straightforward dollar-cost averaging and might be a nice stocking stuffer to think about over the holiday period as we enter a new year. What better way to start off than to find a way to get paid to participate and reduce risk all at once!
Have a wonderful holiday week!
OptionSage
