Trading is about probabilities, and figuring out which way the market might be going. Traders — even when they see telltale signs of a move — typically are unsure about a stock’s direction.
Amid that uncertainty, there is one to potential way to minimize losses in case an unexpected event comes into play.
Waiting for the perfect setup can potentially make you miss out on trading opportunities. Moreover, sizing your trades too large when you see a setup that you like could cause you to get out of a stock, if a downtick happens. These things happen to everyone — myself included — when first starting out.
You see a high-probability setup, get into your max share size, only for the stock to pull back slightly, forcing you out of the trade, and then the stock reverses and things work out the way you thought it would. Here’s where scaling into a trade comes in.
When you scale into a trade, you purchase shares of the stock if it pulls back, rather than being forced out of the trade. In other words, you buy a fraction of your expected maximum position size, and continue to purchase shares until you reach your limit. Ultimately, scaling into positions could potentially maximize your gains, as you dollar-cost average your position. Additionally, when you start with a smaller trade, and scale in as it starts to become profitable, you minimize your risk.
There’s no right way to scale into a trade. You could buy more on a downtick, and look to get out if the stock breaks below a key support area. On the other hand, you could also only look to scale in as a stock continues to rise.
Let’s look at an example of when you might have scaled into a position. Assume you heard about the reports of the WannaCry attacks, and believed this was going to be beneficial to cybersecurity stocks, specifically FireEye Inc. (FEYE). Let’s assume you entered an order to buy ⅓ of the max amount of shares you intend to trade in this stock at $15.50
By scaling in, you are combating uncertainty and minimizing potential losses; going long your max holding would leave you little wiggle room.
As you can see, FEYE pulled back after the open, but you would not have lost much due to scaling in. You still want to get in to your max position; scaling in accomplishes that too.
With that in mind, let’s assume you want to get to your max position size, and you would scale in if the stock pulled back 10 cents. For example, if the stock pulled back to $15.40, you would buy another one-third of your max position size, if the stock fell to $15.30, you’d buy in to reach your max holding size. Let’s assume you set a hard stop around the $15.25.
Thus, your average entry would have been $15.40 ([$15.50 + $15.40 + $15.30]/3); you would have saved 10 cents by scaling in, you would have avoided panicking out by having more money at stake, and you would have gone on to see a nice profit on this particular trade.
The bottom line
Scaling in makes better use of your capital and often allows you to get a better dollar-cost average. It also gives you some room for error, improving both your risk management and your ability to be patient. Just as dollar-cost averaging is a staple of long-term buy-and-hold investors, scaling in should be considered a best practice among traders.
Jeff Bishop is lead trader at TopStockPicks.com. He runs short-term trading strategies, using stocks, options and leveraged ETFs.