When investing, it is often recommended to scale into a position, buying say half at first then adding on as the stock affirms its strength.
While effective in theory, add-on buys can also be dangerous if risk is not controlled as you scale in.
Add-on Buying Dangers
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.
All in all, 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 over doubled:
- 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 (common for CANSLIM type breakouts), the pill is tough to swallow. What was a max $200 loss became a $550 loss.
What is an investor to do?
Well, stocks reversing back into their bases, bull traps, etc. are unfortunately common and impossible to dodge every time. The one factor though always in the control of the investor is capital at risk.
Ways to Manage Risk
There are several ways to manage risk with add-on buys (note options not incorporated here):
Option 1: Stairstep 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 ($2.70 * 75 =$202.50). After the second +25 share buy at $104, raising your stop to $102 would again maintain the original $200 risk.
Pros and Cons: This strategy works great for stocks that go on a strong run with little volatility as your ever tightening Stop has a lower chance of triggering and knocking you out of the trade. On the flip side, this is also the disadvantage. Any time you raise a Stop, you are increasing the risk of being prematurely knocked out.
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.
Pros and Cons: Allows you to maintain your original Stop, allowing for maximum wiggle room for the trade to succeed. On the flip side, less risk means less reward, and your potential gains will suffer as a result.
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.
Pros and Cons: This strategy can work well if done correctly. What matters here is timing and how the trader defines a "confirmation" that the trade is working. In technical analysis this could be moving back above a key moving average, holding an important support level on a pullback, or similar. The quicker buying is also the risk though, as buying into short term strength could be a fake out leading to a reversal.
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.
Pros and Cons: KISS (keep it simple stupid) keeps the trade straight forward and easy to manage which is a big plus, especially for newer traders. On the flip side though, there is a reason why the most successful traders never take a full position straight out of the gate. As the trade begins to confirm itself, the odds for success theoretically increase, thus it is arguably the best time to add to the trade.
Comfort and Confidence is Key
Ultimately, the best strategy to implement is completely up to you and your comfort level.
As you evolve as an investor and work towards sustainable long term trading, your confidence will grow and strategies will become personalized to you and your own trading style.
This is a good thing.
Add-on buys can work wonders and serve as a key to unlocking greater profits. Regardless of what strategy you use, what matters most is that you have rules in place for managing risk.