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Written and copyright © 2009-2013 by Thomas N. Bulkowski. All rights reserved.
Here is a money management technique called zero cost averaging, and it is based
on an article from the April 1998 issue of Stocks & Commodities magazine by Terrence Quinn and Kristin Quinn. It has nothing to do with moving averages or non-moving
averages, or dynamic moving averages, or weighted...well, you get the picture.
Zero Cost Averaging: Opening Position
The idea behind zero cost averaging is to sell enough shares for a profit to equal the cost of those shares without selling them all. An example makes this clear.
Suppose you buy 1,000 shares at $6 each, for a cost of $6,000. If the stock rises to $10, you want to sell enough shares to get back your original cost and hold the remaining shares
essentially for free.
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Suppose the stock does hit $10, then you sell 600 shares, receive $6,000 on the sale, and you're done. You got all of your money back (zero cost), but guess what?
You still own 400 shares (you bought 1,000 and sold 600, leaving 400). That is zero cost averaging. The 400 shares you still own cost you nothing! Yippee!
We can flip this around to determine how much to sell, too, using this equation:
BuyShares = KeepShares + (KeepShares * (100/PercentIncrease))
Where...
- BuyShares is the number of shares you will need to buy;
- KeepShares is the number you want to hold onto after selling the others;
- PercentIncrease is the percentage you want to make on your money before selling.
Zero Cost Averaging: An Example
For example, say you want to keep 100 shares of a stock after it rises 50%. BuyShares = 100 + (100 * 100/50)) or 300 shares.
Say the stock is selling at $10. You buy 300 shares
at a cost of $3000, and when the stock rises 50% to $15, you sell everything except the 100 shares you wanted to keep: 200 shares x $15 = $3000. The 100 shares you keep cost you nothing.
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This is a picture from my garden, just to add some color to this article. Taken in the spring of 2009.
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You
can hold them forever and not lose any money on the transaction, even if the stock were to go bankrupt (of course, the government doesn't see it that way. When you finally do
sell those shares, they IRS will want to take their share. Think of it as your contribution to fund huge bonuses for CEOs when the government loans them your money).
Zero Cost Averaging: Flaw! What Flaw?
The flaw in this strategy is that it requires price to move up in order to sell shares at a profit to get your money back.
What if we create rules that say,
- Buy 50% more shares if price drops 25%.
- Sell 50% of the shares if price climbs 33%.
- Keep 100 shares or more at $0 cost then stop trading.
- Always round up to the next 100 shares (a round lot) when trading.
The following table shows a sample trade when the price bobs up and down between $9 and $12.
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| Item | Price | Shares
Held | Trade | Cumulative
Cost |
| 1. | $12 | 0 | Buy 600 | -$7,200 |
| 2. | $9 | 600 | Buy 300 | -$9,900 |
| 3. | $12 | 900 | Sell (450) = 500 | -$3,900 |
| 4. | $9 | 400 | Buy 200 | -$5,700 |
| 5. | $12 | 600 | Sell 300 | -$2,100 |
| 6. | $9 | 300 | Buy (150) = 200 | -$3,900 |
| 7. | $12 | 500 | Sell 400 (zero cost) | +$900 |
| 8. | | 100 | | +$900 |
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- 1. Buy an initial stake of 600 shares at $12 per share for a total cost of $7,200.
- 2. Since price has dropped 25% to $9, buy 50% more shares (300) for a cost of $2,700 for a running cost of $9,900.
- 3. Price has climbed 33% back to 12, so sell 50% or 450 shares. Since this is an odd lot, increase the share total to 500.
- 4 to 6. Continue buying and selling.
- 7. During steps 1 through 6, we check if selling all but 100 shares would result in zero cost. If so, then we sell those shares and quit trading. In this case, selling
400 would make $4,800, leaving us with a profit of $900 and 100 shares in our portfolio at zero cost.
- 8. Stop trading this stock because we have at least 100 shares at zero cost.
Zero Cost Averaging: Options. No, Not That Kind!
I chose 33% on the buy side instead of 25% to get the numbers to work out evenly. You can chose any numbers you want for the buy and sell sides.
If price were to drop from
$9 by 25% to $6.75, you would buy 50% more shares following the rules outlined. If it climbed from $12 to $16 (33% more than $15), you would sell 50% of your holdings, rounded up
to the nearest 100 shares (or rounded down if selling would leave you less than 100 shares). At each step, check to see if selling all but 100 shares would leave you with at least
100 shares and a profit. If so, then sell those shares and stop trading this stock.
If you zero cost average like this, you can build a diversified portfolio of many stocks held at zero cost. If any of the stocks were to go to $0, you would not lose any money.
Again, all of the numbers are flexible here. You can buy and sell at 10%, 20%, or 50% increments (or whatever). You can look for 1,000 shares at zero cost instead of 100. You can use dollar values
instead of percentages, like buy or sell if the stock price changes by $3 and only trade 200 shares at a time.
-- Thomas Bulkowski
Written and copyright © 2009-2013 by Thomas N. Bulkowski. All rights reserved. Any fool can paint a picture, but it takes a wise person to actually sell it.
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