What Is Scale Out?
Scale out is the process of selling off portions of total held shares while the price increases. To scale out (or scaling out) means to get out of a position (e.g., to sell) in increments as the price climbs. This strategy allows the investor to take profits while the price is increasing, rather than trying to time the peak price. If the actual value continues to increase, however, the investor could be selling a winner too early.
- To scale out of a trade is to incrementally sell a portion of one's long position as the price rises.
- This profit-taking strategy can help reduce the risk of mis-timing the market's high, however it could also risk selling shares too early in a rising market and limit potential upside.
- Scaling out is seen as a risk-averse strategy that can reward investors if the price of a stock subsequently reverses trend and falls.
How Scale Out Works
It only makes sense to scale out of positions only when they are profitable. There is no reason (other than hope) to partially close out a trade once it's proven to be a loser. So rather than setting a single profit target for the entire trade, we can set two or three incremental targets. It's also possible to leave a part of our trade open without a limit at all, and letting an indicator or a trailing stop decide when it should be closed.
This technique reduces overall profit, because, of course, you would have made more if you had left the entire position open for the duration of the entire upward move. However, scaling out protects the profit you have. For scaling out to work well, the market needs to be trending.
Example of Scale Out
As a hypothetical example, if an investor holds 600 shares of a company and thinks the price will stop climbing or will drop somewhere around $41, he or she could scale out by selling 200 shares at $40, 200 shares at $40.50 and 200 shares at $40.75. The average selling price would therefore be $40.42, thus reducing the risk of missing out on profits if the price did drop.
Criticism of Scaling Out
Some critics of scaling out say traders and investors who scale out do so because they took a larger position than they were comfortable with initially. A scale out simply resizes a position to a more correct size for their account size and risk tolerance. Such a trader or investor, critics say, was scared when the original position was on and now have been lucky enough to get some profits. However, what happens to this mindset when the initial trade goes against? Sometimes they let the losses run. As such it's better strategy, critics contend, to size correctly at the start and let profitable run go wherever the investor or trader feels comfortable cashing out.