Common methods: Scaling
Scaling refers to a somewhat systematic approach of getting in or out of a position in phases instead of all at once. Those phases are defined by share or dollar increments up to your maximum investment. The key to using this method is the planning is done in advance (see pyramiding up), not during an active trade (see averaging down). Although this approach appeals to traders who don’t want to jump in (or out) of any investment with both feet, it is likely to increase commission costs. This could reduce your returns and may impact your tax liability.
Consider pyramiding up
If you buy a stock and you find yourself in the rush of a bull market, you may wish to consider increasing your position, buying more shares as the stock price increases. You’d buy shares in chunks up to the dollar investment permitted by your trading plan. After you reached the total maximum investment, you would not purchase any more shares.
This is known as pyramiding up. Although you will be paying increasingly more per share, you are doing so under the presumption that the bull rally will continue and you will be progressively adding to your gains. Then, once the rally shows signs of possibly fizzling out, you can start to exit your position, either quickly or scaling out, as your trading plan, trading style and market environment dictate.
Avoid averaging down
Remember: you’re not married to any given trade. A very common mistake (made by beginners and experienced traders alike) is averaging down on a position after a period of losses, with the intention of exiting the trade as soon as a rebound occurs. This could also be referred to as doubling down.
Imagine you bought 100 shares of a stock at $150 a share, and it goes down to $100. Now the stock will have to go up by $50 just for you to break-even. In such a case, it may be tempting to say, Well, if I buy 100 more shares at $100, my average cost per share will now be $125. So the stock will only have to go up $25 for me to break-even.
As the saying goes, it’s usually not wise to throw good money after bad. Don’t invest more in a stock going the way of the Titanic. Unless you’re looking to scale in to your position as planned in advance over a period of time, don’t fall into that trap. Oftentimes, a stock will simply continue on its downward spiral, and all you will accomplish is to compound your losses. You need to define your acceptable losses before you place the trade and get out when the stock is down by that percentage. Period.
Managing your positions and your emotions effectively are important parts of investing in the markets. No one has a crystal ball when investing or trading. Each trader must make the best decision possible with information that’s available at that moment. Second-guessing yourself will not change the outcome of a trade. Obviously, the more frequently you trade, the more transaction costs you will incur. But if tip-toeing in or out makes it easier for you to manage your positions, these methods may prove to be an effective tool in your investing arsenal.