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Scaling In to ETF Trades

Scaling In to ETF Trades
April 12
00:49 2012

Despite the wealth of available technical indicators, it can still be devilishly difficult to decide precisely when to enter a long position with an ETF. This is often the case when you intend to buy on a pullback, yet the ETF persists in showing signs of weakness. A simple trick for dealing with this scenario is to scale in to the trade.

If you have been trading equities for an appreciable period of time, you are probably familiar with the concept of dollar-cost averaging. It is a principle employed primarily in retirement accounts, with regular periodic investments in the same mutual fund or other investment vehicle. The result is that more shares are purchased when the price is lower, which dilutes the overall average cost of the investment.

Scaling in is merely a short-term version of DCA. Rather than entering a long position all at once, you can break up your purchases into two or more blocks. This offers some protection should the ETF drop further after your initial purchase, giving you an opportunity to buy at a lower price, and it also serves to reduce your losses should the trade go entirely bad and have to be exited at a loss.

Say that you have seen a trading signal appropriate to your strategy—for example, the ETF has dropped below its moving average (of whatever lookback period you employ), and the price has fallen in two consecutive trading sessions. You might choose to go long in anticipation of the bounce. What if, however, the ETF bounces only weakly or continues to trade down? Now you’re faced with an unpleasant choice between abandoning the trade at a loss or staying with it and hoping that this isn’t the beginning of a downturn.

Scaling in sacrifices some potential gains for a higher degree of safety. You can go long with half the funds assigned to the trade when the ETF first breaks down, waiting two to three more sessions to see what develops. If the ETF bounces but then corrects further, you can buy in with the second half of your funds and achieve a lower average cost for the trade. If the ETF simply falls off a cliff after your initial buy, you can exit with half the losses you would have incurred otherwise.

Let’s look at an example: the iShares MSCI Brazil Index ETF (EWZ). From the beginning of 2012 to March 5, it mounted a long-term climb. Then a doji on March 2 was followed by a close near the intrasession low on March 5, just above the 20-day moving average (MA). The next day, March 6, would have looked like a good day to buy—a doji followed by two bearish closes, the second one below the MA. Sure enough, EWZ bounced in the next two sessions, but only weakly in the second one on March 8. Then it fell on March 9 and gapped downward on March 12.

A scale in to this trade would have involved buying half the long position on March 6, watching the ETF’s activity, and buying the second half of the position on March 12. From there the ETF moved back toward the 20-day MA, but since in this case it failed to cross, you probably would have chosen to exit on bearish closes on March 15 or 16—which still would have netted a gain.

While it is of course impossible to predict exactly what your trade prices would have been, the closes on March 6 and 12 were $66.61 and $66.27 respectively. That yields an average cost for the trade of $66.44. The closes on March 15 and 16 were $67.66 and $67.56, so you could have produced over a dollar a share from this trade in two weeks or less.

So while many traders may ignore DCA as a technique strictly for long-term investors, the same principles can be applied to some short-term trades. Use scaling in to hedge your bets when the indicators just aren’t clear enough for your satisfaction.

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