Last Update: July 2021

If you’ve been lulled to sleep by the summer doldrums then WAKE UP! Today’s topic was prompted by yet another query by Keren in the Clubhouse. She’s batting two-for-two now when it comes to intelligent questions. I’ve reposted the question and my answer below.

I have a question about the technique of scaling in. I understand the concept and appreciated the write up in the Options Report. However can scaling in also be viewed as Dollar Cost Averaging since you are increasing your position as the security is going against what you anticipated when you first entered the trade? I was under the impression that Dollar Cost Averaging is not the best technique unless you are treating your strategy as an investment. How do you avoid digging yourself into a bigger hole since you are essentially increasing your position size as the trade is going against you?

First up, the Options Report she’s referencing that has the commentary on scaling in can be found here. If you’re a pro member, read that first to get the context. If you’re not a pro member, I’ll provide an example.

Scaling in refers to entering part of your position now and part later. Let’s say you sell a Sep $14.50 put in SLV for 15 cents. Then later you add another one for 25 cents. By adding a second one at a higher credit, you’ve raised the average credit to 20 cents ((25 + 15) / 2). Got it?

First question: Can scaling in also be viewed as Dollar Cost Averaging (DCA)?

Answer: yes.

Second question: I was under the impression that DCA is not the best technique unless you are treating your strategy as an investment.

Answer: the devil’s in the details. Like any trading technique, there’s a right and a wrong way to implement DCA. To follow along you first need to have a basic understanding of what it is. Rather than re-invent the wheel I’m sending you to Investopedia to read up on it. See here.

The Right way to Dollar Cost Average

From an investment standpoint, most people DCA because they don’t have an alternative. You get more money from work every month so you keep adding a bit to your investments. A while back I used to invest a couple hundred bucks a month for my kids in a variety of Vanguard ETFs (VTI, VB, VNQ, etc…). It was appropriate because A) I didn’t have all the money to invest upfront, B) I wanted to hold these ETFs long-term, C) I was confident they weren’t going to zero, D) I was comfortable with the amount of money I had at risk in the positions.

Now, that’s a classic example of how most investors DCA. And, yes, I was “treating my strategy as an investment.”

Where people go wrong with DCA when investing is they don’t diversify. Maybe I pick one stock, say, SNAP, and throw money in it every month. That’s a bad idea because SNAP can go to zero. The only reason it would be appropriate is if you were putting in a small enough amount of money that you didn’t care if you lost it all.

Now, here’s how you would use DCA when trading. I most often use this with option selling so that’s the example I’m going to use. On Aug 4th I sold a Sep $155/$160 bear call spread in HD for $1.06. The stock had a bear retracement pattern and I thought it would roll over.

I was wrong.

It continued rallying and then finally started to show intraday weakness on Aug 7th. As a result, I added another batch of Sep $155/$160 bear call spreads for $1.60. That raises my average credit to $1.33 (($1.06 + $1.60)/2). The biggest benefit is now when HD drops back I will recover my loss quicker.

Proper Sizing

Final question: How do you avoid digging yourself into a bigger hole since you are essentially increasing your position size as the trade is going against you?

Answer: It all comes down to proper position sizing. You have to plan on scaling in at the outset of the trade. Let’s say my plan on HD was to exit if it tags $155. And, my acceptable risk per trade is $250. If the first bear calls I entered would lose only $125 based on my planned exit, then I have the ability to double the size without exceeding my risk limit. That’s the KEY! If I start with half-size then I can always double it and still be wrong and not lose more than is prudent.

What you wouldn’t want to do is risk a full size with the initial trade and then double or triple it because you’re trying to throw a hail mary to get back your money quicker.

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