What Is to Scale Out?
To scale out is the process of selling off portions of total shares held while the price increases. To scale out, or scaling out, means to exit a position by selling in increments as the price of the stock climbs.
- To scale out of a trade is to incrementally sell a portion of one's long position as the stock price rises.
- This profit-taking strategy helps reduce the risk of missing the market's high.
- Scaling out risks selling shares too early in a rising market and limiting potential gain.
- Scaling out is viewed as a risk-averse strategy that can reward investors if the price of a stock subsequently reverses trends and falls.
Understanding Scaling Out
Scaling out of a stock lets an investor reduce exposure to a position when momentum seems to be slowing. The investor takes profits while the price is increasing, rather than attempting to time the peak price. If the value continues to increase, however, the investor could be exiting too early.
To scale out of positions makes sense only when they are profitable as there is no reason to partially close out a trade once it's proven unprofitable. Rather than setting a single profit target for the entire trade, an investor can set two or three incremental targets. It's also possible to leave a part of the trade open without a limit at all and let an indicator or a trailing stop decide when it should be closed.
This technique reduces overall profit because investors would have gained more if the entire position remained open for the duration of the entire upward move. Scaling out protects the profit and for scaling out to work well, the market needs to be trending.
For example, if an investor holds 600 shares of a company that has an average price of $20 and they believe the price will stop climbing or will drop to $40, they could scale out by selling 200 shares at $39, 200 shares at $39.50, and 200 shares at $39.75. The average selling price would therefore be $39.42, thus reducing the risk of losing profits if the price did decrease.
Criticism of Scaling Out
Some critics 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 and risk tolerance. Such a trader or investor, critics say, was scared when the original position was on and now has been lucky enough to gleen some profit.
However, what happens to this mindset when the initial trade goes lower than the entry price? Sometimes they let the losses run. As such, it's a better strategy, critics contend, to size correctly at the start and let a profitable run go wherever the investor or trader feels comfortable cashing out.
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