When investing, many theories about position management often recommended scaling into a position. Usually the thought is that the investor is buying say half at first then adding on as the stock affirms its strength.
While this is very effective in theory, add-on buys can also be dangerous if risk is not controlled as you scale in. So today, let's take a look at a few examples and focus on the risk associated with scaling in.
Dangers of adding on.
Let's say we want to buy into a position of 100 shares of stock that is currently trading at $100 per share. Instead of buying all 100 shares at once, we buy 50 shares now at $100 and set our stop loss at $96 (4% or $200 max risk).
The stock then moves up to $102, confirming our bullish stance, and we decide to add 25 more shares at $102. Then, the stock moves up to $104 the next day, and we add the remaining 25 shares to bring our position to 100 shares even.
Now with our full position we feel good because we scaled into the position, buying as the stock moved up in price.
However, what we don't realize is that our capital at risk has now more than doubled. Here's the breakdown:
•Buy 1: 50 shares @ $100, Stop $96. Risk = $200 or 4% ($200 / $5,000).
•Buy 2: 25 shares at $102, Stop $96. Risk = $350 ($200 + $150) or 4.64% ($350 / $7550) .
•Buy 3: 25 shares at $104, Stop $96. Risk = $550 ($200 + $150 + $200) or 5.42% ($550 / $10,150).
This is where investors get caught, because if the stock reverses back below $100 and knocks them out at $96 (which has happened to all of us), the new loss can be a little tough to handle. What was a max $200 loss became a $550 loss.
So what are we to do?
There are several ways to manage risk with add-on buys:
Option 1: Stair step your Stop as you go. With $200 original risk, as soon as the 1st +25 share buy comes in at $102, you can maintain that $200 risk by raising the stop to approximately $99.30. After the second +25 share buy at $104, raising your stop to $102 would again maintain the original $200 risk.
Option 2: Adjust your position size to account for additional buys. If $200 is the most we wanted to risk on the trade overall, then arguably 100 shares should have never been our target position size to begin with. Perhaps the magic number was 50 shares; buying 25 initially (which means $100 of Risk to start), and upon price action confirmation, adding onto the position knowing our Risk is going to increase as the trade evolves.
Option 3: Accumulate your full position more quickly. Instead of waiting till $102 and $104 to add on to our position, buying at $101 and $102, for example, would get us our full 100 share position faster, thus limiting capital at risk and potentially allowing us to maintain our original Stop.
Option 4: Buy the full position straight from the beginning. For $200 total risk, 50 shares would have been the preset position size for the trade right from the start ($100 stock, $96 Stop = $4 risk x 50 shares = $200). As the stock increases to $102, $104, and beyond you are already in the lead and have ample room to play the trade.
While adding to a winner is a great way to step into a position, my personal preference is to start the position with full size and a stop, then step OUT of the position as it heads in my favor. This helps reduce the risk on the way up and you can allow the stop price to stay the same. If it hits the stop then you have a smaller loss or break even (depending on how many shares you have sold for a profit).