Even with the awesome tools provided by TradeSmith Finance, I can never time the market with 100% precision. No one can, despite what you may hear. This simple fact holds back many traders who believe they can pinpoint the top or bottom of a stock or index down to the penny. To get around this, many scale into and out of positions as an alternate strategy to just buying and selling. But they do it incorrectly.
You see, while it might sound counterintuitive, the best practice for this strategy (also referred to as dollar-cost averaging) is to scale out of stocks in an uptrend — taking profits off the table — and into stocks in a downtrend — thereby lowering your average cost of entry. Let me explain why this works and how to combine it with stop losses.
How many times have you taken a profit on a trade, only to watch it run up another 5%? You say to yourself, “If only I could pick the top.” That thought right there sets you up for failure because you then focus on trying to get a better and better number until you miss taking any profits entirely. None of us knows whether a stock will keep running higher after we exit or lower after we enter.
We can work around this by scaling into and out of trades. “Scaling” simply refers to the act of entering and exiting a position at different points. Let’s say you want to buy stock ABC on a pullback. You identified $20 as your entry price. However, you know the stock can go as low as $15. The odds it will get down to $15 are about 50/50. So, you decide that you will buy 100 shares at $20 and 100 shares at $15.
Based on the probabilities and your entry plan, you’ll either end up with 200 shares at an average cost of $17.50 or 100 shares of stock at an average cost of $20. If you always wait for $15 to buy 200 shares, you would miss out on the trade entirely 50% of the time. But if you buy all 200 shares at $20, you could make less money than you might have.
The same concept works when you exit a trade. You can take all of a position off the table at a given price. But you never know how much farther a stock might run. Scaling out of the trade allows you to lock in some profits while trying to squeeze out more.
Scaling Done Differently
Here’s a secret that most people won’t tell you about scaling or dollar-cost averaging: It only works when you are going against the trend. This is counter to our TradeSmith trend indicators and our usual entry/exit strategies, but it works for this particular strategy.
- If a stock is in an uptrend, it’s best to scale out of a long position, not into one.
- If a stock is in a downtrend, it’s best to scale into a long position, not out of one.
Example 1: Scaling In
Let’s go back to the end of February 2020 for an example. The S&P 500 hit a high of $3,393.52 on Feb. 19. Stocks tumbled over the next month, bottoming at $2,191.86 on March 23.
From there, the market turned higher, as health improved. On March 27, TradeSmith Finance provided an entry signal when the S&P 500 closed at $2,541.47. Let’s say you decided to reenter the market right there. Let’s compare the two possible outcomes for a real-life example.
- You put 100% of your capital to work right away.
- You put 50% of your capital to work right away and another 50% at a lower price.
Since the market was in a strong uptrend, if you chose Option 2, you would have risked not putting all your money in and missing out on potential profits. Over the next two days, the market dipped down to $2,447.49. Under Option 1, if you had shoved all your chips in at the close of March 27, you would have missed out on a lower price point by $93.98. That’s not that much considering the S&P 500 already moved $349.61 off the bottom before the entry signal arrived.
Under Option 2, you would need to make sure you put your money to work before the market hit its next low of $2,447.49. Here’s why Option 2 is a problem in an uptrend. Upward momentum favors shallower pullbacks and higher prices. If you didn’t get all your money in at some price between $2,447.49 and $2,541.47 in the S&P 500, you would miss out on profits. And considering markets went on one of the best bull runs in history shortly thereafter, that is a big risk.
Example 2: Scaling Out
On the flipside, scaling out of a long position into upward momentum works. Let’s take a look at SunPower (SPWR).
When TradeSmith Finance signaled an entry on Aug. 27, shares traded at $11.05. In January, the stock hit a high of $57.52. Let’s say that I wanted to lock in profits as I went along while using the TradeSmith Health Indicator as my ultimate stop loss. For this example, we’ll say that I sold 50% of the shares I had remaining at any given point every time the stock climbed by $11.05. If I bought 2,000 shares, that means I sell at the following prices:
- 1,000 shares at $22.10
- 500 shares at $33.15
- 250 shares at $44.20
- 125 shares at $55.25
- 125 shares at $23.61 (Since the high was $57.52, I can’t scale out any more at higher prices. So, I just hold the remaining 125 shares until the stock enters the TradeSmith Red Zone at $23.61.)
That makes my average exit price per share $29.79 — an average gain of 169.59%. This works well because the uptrend kept pullbacks shallow and kept moving prices higher. It wasn’t until the stock flipped into a downtrend that it finally hit my stop loss. Now, you might be asking why I don’t talk about scaling into a trade that’s in a downtrend. While that’s certainly an option — and it’s the only way to successfully dollar-cost average — the strategies I use with TradeSmith Finance favor going with momentum, not against it. That said, you can even use this strategy intraday to scale into or out of a position.
As you can see, using momentum as my guide, when I incorporate scaling and a trailing stop, I’m able to maximize my potential profits without trying to necessarily time my exits.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.