Stock prices never go straight down or straight up, which is why many traders use limit orders, or simply try to buy on down days and sell on up days. But picking the perfect entry and exit price for a stock you own or would like to own, is a nearly impossible, often frustrating task. Inevitably, no matter how long you wait for the perfect entry price, as soon as your order is filled, the stock often seems to drop further in price. Likewise, after waiting for your position to reach what you think will be the perfect selling price, the price often seems to climb even higher after you sell.
It’s not really necessary to pick the exact top or the exact bottom to be a successful trader; but it will definitely help if you can get somewhere close. This is why I advocate scaling into and out of your positions, especially during times of higher market volatility. Keep in mind that using this strategy will increase your commission costs, potentially significantly, because you’ll be making more trades.
From the market correction of August 2015 into the first quarter of this year, volatility, as measured by the CBOE Volatility Index (“VIX”), was elevated. Periods of high volatility usually mean large day-to-day (and intraday) moves in both directions, and such periods often provide good examples of why scaling in and out of positions can often be an effective way to improve your trading results. For the following examples, we’ll focus on the period just after the August 2015 correction, as that is a time when bargain hunters might have been inclined to buy. Consider this first scenario:
- In late August 2015, the SPX experienced its first market correction (decline >10%) in 48 months. After bottoming out on 8/25/15, by 8/27 it had experienced two very large gains totaling more than 120 points (+6.4%) total. Suppose you believed at that time that the worst was over and a buying opportunity was at hand. Therefore you decided to establish a position of 1,000 shares of the SPDR S&P 500 ETF (SPY). We’ll call this scenario 1.
- If you bought 1,000 shares near the August 27 closing price of $199 and the market continued to move up over the next 10 weeks, you could have realized a nice profit. However, the VIX (CBOE Volatility Index) closed at 26.10, indicating that market participants believed the SPY would be between about 147 and 251 approximately 68% of the time over the next 12 months. This was by no means a low-risk scenario.
- If the SPY had reached $251, six months later and you earned a profit of 26%, you would feel pretty good. However, imagine how you would feel if six months later the SPY was at $147. You would have sustained a loss of about 26%.
Since you had no way of knowing for sure if the market had indeed bottomed on 8/25, you might also have considered scaling into this position over time. A standard (time-based) dollar-cost-averaging strategy typically involves buying equal quantities at fixed time intervals. We’ll call this scenario 2:
- You would start by buying 100 shares of SPY at $199.00 on August 27. Then you’d purchase another 100 shares at the beginning of each week over a period of 10 weeks. If the market moved lower the next week, you would buy an additional 100 shares at a lower price. If the market moved up the next week, you would buy an additional 100 shares at a higher price. If you continued to purchase an additional 100 shares each week, some at higher and some at lower prices, you would eventually end up with 1,000 shares at a more favorable average cost basis than if you had purchased all 1000 shares at once. Once the market eventually moved higher, your profits would be higher than if you had bought the full 1,000 shares at one time.
- A side benefit to this method is the ability to change your mind mid-stream. Suppose you were using this strategy over a 10-week period, but the price began to rise too sharply before you were able to buy the full 1,000 shares, you could always stop buying them and simply limit your position to less than 1,000 shares. If you end up with less than 1,000 shares, you may miss some opportunity, but you will have taken on much less risk than if you had purchased the entire position at once.
Price based vs. time based
Another strategy may be to consider scaling in based on price instead of time. We’ll call this scenario 3:
- You would start by buying 100 shares of SPY at $199.00 on August 27, and then buy additional shares any time over the next 10 weeks, but only when the price was lower than the previous purchase. After your initial purchase, if the market moved lower the next week, you would have the opportunity to buy an additional 100 shares at a lower price. Then, if the market moved lower again, you could buy an additional 100 shares at an even lower price. You might even make more than one purchase in the same week if prices were dropping.
- If you are able to acquire a full 1,000 shares at successively lower prices, then when the market eventually began to move higher, your profits would be higher than if you had bought the full 1,000 shares at one time or at fixed time intervals.
- As with the time-based strategy, with this price-based strategy, you also have the ability to change your mind mid-stream. If the price began to drop too sharply before you are able to buy the full 1,000 shares, you could always stop buying them and intentionally limit your position to less than 1,000 shares. While you will have some risk, you will have taken on much less risk than if you had purchased the entire position at once or over time.
- Or if you stick to the price rules, it may happen automatically. Meaning if the price rose too quickly, you could end up with less than 1,000 shares and you may miss some opportunity, but again, you will have taken on less risk.
Consider the table, below which compares these three scenarios using actual prices, with the assumption that you are able to obtain the full 1,000 shares over a period of 10 weeks or less.
As you can see, in this table the full-position entry on day one results in a 1,000-share position with a cost basis of $199.00 per share, compared to an average cost basis of $198.49 per share for scaling in based on time, and an average cost basis of $193.50 per share when scaling in based on price. Even when the additional commission costs are included, you can see that scenario 2 results in a total initial cost savings of $425.45 and scenario 3 results in a total initial cost savings of $5,419.45 over scenario 1.
The table above illustrates the actual prices of the SPY in the weeks following 8/27/15. Whether or not August 24 turned out to be a market bottom or not, the two scaling in strategies could still end up being more profitable in the long run. Clearly, in times of lower volatility these strategies would still be beneficial, but likely to a lesser degree.
Remember, both scaling in strategies could cause you to end up with a position of less than 1,000 shares, if the price were to rise too sharply. However, by that point, you would typically be profitable and you would have taken on less risk in getting there.
Scaling out (detailed strategy)
Just as we’ve discussed how scaling in can be beneficial when you believe the market is close to a bottom, scaling out can be equally beneficial when you believe the market is close to a top; consider using the price-based scaling strategy in reverse. For example, if you own 1000 shares of SPY and you believe the market may be close to a top, consider selling only 100 shares. Then if the market moves higher in subsequent days, sell another 100. Each time the market moves higher, sell another 100 shares, but if the market moves lower, don’t.
If the market moves generally higher over several weeks, eventually you will have sold all 1000 shares at progressively higher prices. However, if the market peaks and begins to decline before all of your shares are sold, you may still own some shares of SPY, but any risk due to the decline in price of the shares you still own, will have been greatly reduced by the fact that you own less than 1000 shares.
Scaling out (simplified strategy)
When it comes to selling and taking profits, some traders believe that when “the time is right, the time is right”. But unless you have had great success at pinpointing the exact top of the market, consider the following simplified plan for scaling out of a position, as it has the potential to leave you feeling pretty good no matter what the outcome. The simplified plan is so simple it can be described in only two words, “Sell half”.
For example, if you own 1000 shares of SPY and you believe the market may be close to a top, consider selling only 500 shares. Then if the market moves higher in subsequent days, you’ll likely be pleased that you held the other 500 shares, which can now be sold at a higher price, resulting in a higher aggregate profit on your full 1000 share position. If however, the market moves lower after you sell your first 500 shares, you’ll likely be pleased that you sold the first 500 shares before the price declined, because you not only locked in a higher profit on those shares, but you also cut your losses in half as your remaining shares declined in price. I know this sounds very simplistic, but try it once and you’ll wonder why you hadn’t considered it before.
Don’t focus on the bottom
It’s virtually impossible to predict the exact bottom or top of the market—but you don’t have to. If you can just get anywhere close, you can often scale into or out of the market over a period of time, and improve your overall profitability in the end.