This story was originally published here.
Lots of novice traders get it backwards…
Instead of reducing risk, they trade in a way that increases risk.
They tell themselves that it's the smart move… that they're increasing their profit potential.
But really, they just have a hard time admitting that they're wrong and cutting their losses. They set themselves up to fail.
Today, we'll show you how to avoid that mistake. It's a simple technique you can use to increase your profit potential, reduce your risk, and set yourself up for long-term trading success.
Let's start by looking at the wrong way to do things…
We'll call our novice trader “Joe.”
Joe has a $100,000 investment portfolio. He finds a stock that's trading at a low valuation. He feels the business is misunderstood. And the price chart looks like it's forming a bottom.
Joe gets excited about the setup… So he puts 2% of his $100,000 investment portfolio into the stock. That's $2,000. He figures he doesn't need an exit strategy on this one… He'll play it by ear.
Things start off well. The stock rises 5%… then 10%. It's looking like a winner. And it feels good. But the stock soon heads south. And before he knows it, Joe is down 20% on the trade. His $2,000 is now worth $1,600.
He thinks, “I know this is a great stock. It went up right after I bought it. It will go up again. I should take advantage of this drop to add to my position at a lower price.” So… he buys another $2,000 worth of shares. Joe now has $3,600 in a losing trade.
Joe's idea doesn't work out. He finally throws in the towel after his stock falls another 20%. The result is a $1,120 loss.
Instead of cutting his losses after the initial 20% drop – after the apparent “bottom” fell out – Joe added to his position. He turned what should have been a small $400 loss (just 0.4% of his total portfolio) into a more significant $1,120 loss (1.12%).
Joe's actions may seem crazy written out like this… And they are. But a lot of people do the same thing… repeatedly. If you've never made this mistake, we'd bet you're in the minority.
This “strategy” is so common, it even has a name: “averaging down.” By buying more shares at a lower price, the average cost per share drops.
This is completely backwards. Instead, you should consider the alternative: “scaling in.”
Scaling in to a trade involves starting with a smaller-than-normal position, and building that position over time. There are different ways to scale in… But here's one we've used with success in our DailyWealth Trader (DWT) newsletter…
First, you choose your stop loss. Then, you buy a small position. Maybe it's one-third of what you consider “normal” for a speculation.
If shares drop to your stop loss, you're out. You take a tiny loss and move on.
If shares rise, and the trade still looks good, you add another one-third position. At this point, you tighten your stop loss. You do this in a way that keeps your potential loss on the combined position as small as or smaller than your original “tiny” loss potential.
In other words, you can reduce your risk and increase your profit potential at the same time.
If shares continue rising, you can do the same thing again. Buy more and tighten your stop.
At this point, your worst-case scenario will likely be closing the trade for profit. Your best-case scenario is big profits on a speculation that had very little risk, from start to finish.
Now, let's look at an example of this idea…
Imagine you find a cheap, misunderstood business. We'll call it Acme Corp (ACME). Acme's price chart looks like it's forming a bottom. And you think it has at least 100% upside potential.
Acme has a history of being volatile. So you want to use a wide, 33% stop loss…
Because you're using such a wide stop loss, you only buy a one-third position. Maybe you would normally put $3,000 into a stock like this. So you start with $1,000 instead. Shares are trading at $20… So you buy 50 shares.
Two weeks after you buy, Acme is off to a great start… You're up 20% on the trade. Then, after a month that included a big drop and an even bigger rally, you're up 35%. Shares trade at $27. And your position is worth $1,350.
Now that you're up a lot, you buy another one-third position… And you tighten your stop loss from 33% below your purchase price to 28% below the current $27 share price. (Your stop goes from $13.40 up to $19.44.)
This move – adding more shares and tightening your stop loss – increases your profit potential and reduces your risk.
Keep in mind, adding another one-third position won't double the number of shares you own. A $1,000 purchase bought you 50 shares at $20. Another $1,000 will buy you 37 shares at $27.
Your combined $2,000 investment in 87 shares of Acme is now worth about $2,350. That's a 17.5% profit on your combined two-thirds position.
You started out with a one-third ($1,000) position size and a 33% stop loss. So you risked $330.
Now, you've invested $2,000. If the stock falls to your new stop loss (of $19.44), your 87 shares will be worth $1,691. That's a $309 loss – less than the $330 you initially risked.
And you're still giving the stock 28% worth of “wiggle room.”
If shares rise another 35%, you may decide to add another one-third position. Now, if you tighten your stop to 25% (below the current share price), you would still book a profit even if you stopped out.
Of course, that's looking at the worst-case scenario each step of the way. On the upside, you'd now have 114 shares – or 128% more than you initially purchased. Your upside from this point forward is dramatically larger… And at no point did you risk even $1 more.
Here's what we want you to take away from this essay…
When you scale in to a position as it moves in your favor, you will always risk less than if you buy a full position all at once.
And because you're already profiting, you know the market agrees with your idea. Unless something changes, you should continue to make money.
When you average down as a position moves against you, you're adding to your risk even though the market is telling you you're wrong. Unless something changes, you should continue to lose money.
In sum, don't be like “Joe.” The next time you get excited about a speculation, think about how much you're willing to risk before you think about the upside potential.
If you're right and it does have triple-digit upside, you'll still make great money by scaling in. The only thing you'll lose with this strategy is an unacceptable amount of risk.
This is how trading pros increase their profits without increasing their risk. And now you can use this strategy, too.
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