By Mike Tibbits, YouCanTrade Content Specialist
Whenever the market or a specific stock crashes, I get excited because that means I can take advantage of the temporary drop in stock prices and start buying shares of stock to add to my portfolio. One thing to keep in mind is a market or stock crash usually doesn’t stop after a one-day selloff. Crashes can last days or sometimes even months which lead into bear markets, so it’s important not to go all in on the first day of a huge selloff.
Dollar Cost Averaging
One way to buy stocks in a falling market is to apply a technique known as “Dollar Cost Averaging.” This is when you put yourself on a budget and buy a fixed number of shares or a set dollar amount of the stocks you want on a recurring basis. You could think of this like paying a monthly bill, except you are buying stocks instead. By buying a few shares of stock every month, your cost basis will begin averaging in the costs when the stock was purchased at lower and higher prices.
Applying the concept of Dollar Cost Averaging during falling markets is a strategy known as Averaging Down. This can be an effective way to attain a large position over time while controlling how much capital is exposed to the markets.
Trade Example: Advanced Micro Devices
Instead of an arbitrary XYZ stock story, let’s take a look at a real-life example. On October 8, Advanced Micro Devices (AMD) was trading at intraday highs of 88.72. Around noon that day, AMD held a live streamed event unveiling a new generation series of processors that were just made available for purchase. Immediately after the announcement, the stock sold off, dropping roughly three percent in a matter of hours.
Now, say a hasty trader wanted to take advantage of this selloff and purchased 100 shares of AMD that day. Let’s also say our hasty trader was lucky and was able to buy 100 shares at the lowest price of that day which was $85.95 per share. He has now exposed $8,595 to the movements of both AMD and the markets in general.
Now, let’s look at our more cautious trader, who is thinking the same thing as our hasty friend above, but decides to apply a Dollar Cost Averaging strategy instead. Our cautious trader decides to buy 10 shares at the closing price beginning on the day of the news event and will continue to buy 10 shares per day at the closing price over the next 10 days.
Summing it up
|red* = Hasty Trader Entry||Purchase Price||Cumulative Risk|
|October 8, 2020||$85.95||$8,595.00|
|blue* = Cautious Trader Entry||Purchase Price||Cumulative Risk|
As you can see, as of October 23, AMD closed the day at $81.96 per share. Our hasty trader who had bought 100 shares of AMD all at once at $85.95/share is down $399. Our cautious trader, on the other hand, who has an average cost of $83.245/share, is down only $128.50. Our hasty trader is down nearly triple the amount the cautious trader is.
Keep your cool
The next time you see a stock crashing, don’t act hastily. You never know what could happen the next day. Don’t let the fear of missing out on what may seem like a good trade be the impulse driving you into a position. Big crashes usually take time to recover and will encounter some bumps along the way. By using Dollar Cost Averaging, you get to enjoy the days where the stock dips down as it lowers your average cost per share.