Initiating a trade is one thing. It is quite another to manage your unrealised gains. This week, we discuss an approach called zero-cost averaging that you can consider for managing profitable trading positions.
Managing gains
Your trading plan typically has three price points: entry price, price target and stop-loss. For zero-cost averaging, you need another parameter: the number of contracts you want to hold to capture additional gains if you hold a view that the price can move up further after it reaches your initial price target.
Suppose you expect the futures price to move up 20 per cent. Also, you want to hold one contract after the initial price target is reached. Then, you must buy six contracts. You can determine the number using this equation: number of contracts you want to hold + [number of contracts you want to hold * (1/expected percentage gains)]. Therefore, for holding one contract with an expected upside of 20 per cent, the calculation is: 1+ [1*(1/0.20)] = 6.
The above equation leads to several observations. One, this may not work for individuals who trade one contract at time. Two, the rule works only if you expect significant gains in the futures price; for lower the expected gains, the greater the number of contracts you may have to buy, requiring larger trading capital.
How does the rule work? Suppose you bought six contracts when the futures price is 1,000. When the price moves to 1,200 (20 per cent higher), you must take profits on five contracts and hold one contract if you believe there is a further upside potential. You recover your initial cost when you take profits on the five contracts. So, the contract you hold for further upside has zero cost. Hence, the term zero-cost averaging.
This approach can also be useful when you want to roll over your futures position to capture a strong potential uptrend in the futures price. For individuals who trade two or more contracts, a simple alternative is to hold one contract with a trailing stop loss and sell the remaining at the first price target. The biggest difference is your emotion associated with the trade. Once you take out your initial trading capital, you may be able to trade with confidence in the case of zero-cost averaging. With trailing stop-loss, you may still worry about giving-up unrealised gains or incurring losses on the existing position.
Who benefits
Zero-cost averaging can be applied on underlying assets for all traders and on futures contracts for traders with large capital
Optional Reading
Zero-cost averaging can be applied on underlying assets for all traders and on futures contracts for traders with large capital. It does not work for option contracts because of time decay; the sooner you take profits on your option positions, the better. Note that zero-cost averaging does not consider rollover costs for futures. It is moot if you should trade the zero-cost position without a stop-loss; after all, you risked your trading capital to generate gains to make the position zero cost.
(The author offers training programmes for individuals to manage their personal investments)
