Most novice investors take a strictly linear approach to investing. They identify an opportunity, buy a position, and then, at some predefined point, they’ll close that position. It’s binary. Either open or closed.
Of interest though, as your position size increases (and we’ll be talking about “proper” position sizing later on), some markets may lack sufficient liquidity to allow an “all in/all out” approach.
That’s not the only reason for moving away from a strictly linear approach, however. There are many instances where you can increase your profit potential by selectively adding to the size of a particular position. The following rules have been time-tested and are based on both hands-on experience and logic. They will serve you well:
• You should only add to positions in the direction of the market, so for instance, if you have adopted a long position, you’ll add to it as the market moves up, which is to say, you average your cost upwards.
• Anytime you add to a position, do so incrementally, and in successively smaller amounts than your initial position. This is known as “Pyramiding,” because your position is built like a pyramid, with the largest segment being purchased at the lowest price, and successively smaller positions as the price moves higher.
• Never add to your position against the market. This is the reverse of the first point and is called “averaging down.” It’s a surefire recipe for disaster.
Related to this discussion is finding the ideal entry point for any given position. Opinions vary wildly here and tend to fall into three basic categories. We leave it to your discretion to determine which of these is best for you:
• Enter your position before the “break out.” This typically involves buying at or near the low point of a pattern where the risk is quite small. The tradeoff is that although the risk of a loss is small, there’s also a risk that you won’t see a breakout at all, and if you do, you may find yourself paying a high opportunity cost because you might have to wait an extended period of time for it to occur.
• Enter your position on the “break out.” This has the advantage of reducing your opportunity cost but increases your overall risk in two different ways. First, the break out could fail to materialize, and should the price fall, you run the risk of seeing much higher losses unless you move swiftly and decisively. Second, as the pattern unfolds, a much better entry point may present itself. By “entering high,” you’ve just blunted your potential profits.
• Enter your position on a pull back from a “break out.” We regard this as the best approach of the three on logical grounds, but it does suffer from one big potential problem. If the price really takes off and there is no pull back, then you’ve missed the opportunity entirely. This is a very real risk, because many of the biggest market moves don’t have a significant pull back.
Many experienced traders take a hybrid approach, adopting one third of a position before the break out, another third at the break out, and the final third on the pull back, if one occurs. That has the obvious advantage that whatever happens, you’re in position to take advantage of it.
Of course, the drawback is that if no pull back occurs, your position size is one third smaller than it would have been if you’d adopted one of the approaches exclusively. In any event, that gives you a (potentially) fourth strategy to adopt, IF you’ve got the discipline to pull it off, which again, relates back to the psychology of trading.
Note that it’s also entirely possible to construct a “staged” exit strategy, which serves as the inverse of the entry strategy briefly described above.