When a stock is breaking out in one direction or another, it can be very easy to trade. But what should you do when a stock is churning sideways for what seems like forever?
You can always try to buy at the bottom of the range and sell at the top. But it's easy to get whipsawed in that situation.
Another option is to use scale trading to profit from a range-bound market. Read on to find out how.
What is scale trading?
Scale trading is a strategy that involves gradually increasing a position as the price of a stock falls, then decreasing as the price goes up.
For example, look at this chart of the VanEck Vectors Gold Miners ETF (GDX):
At the time of this writing, GDX has been stuck in a range for the past 5 months.
A normal, run-of-the-mill strategy to trade this stock would be to buy 5,000 shares (or some other large amount) every time the price gets down to $21 and sell 5,000 shares every time it gets up to $25.50. But the price bounces around a lot, so this might be a very stressful way to trade. And you might have to wait a long time before this trade would pay off.
A scale trading strategy, however, would involve buying a smaller amount after every 50-cent drop in price and selling that same amount after every 50 cent increase in price. These 50-cent increments are shown as horizontal lines on the chart above.
For example, instead of waiting until the price got to $21 to buy 5,000 shares, you could have bought 500 shares at $25. Then, if the price had fallen to $24.50 (as it did here), you could have bought another 500 shares. You could have then bought another 500 shares every time the price fell by 50 cents.
In this case, by the time you got to the bottom of the range at $21, you would have already bought 4,500 shares of GDX. Then, as the price rallied up to $21.50, you could have sold off the 500 shares you previously bought at $21. And then you could have continued doing this at each horizontal line shown on the chart; selling a few more shares each time the price rose.
If the price reversed and headed back towards the bottom of the range again (like it did at $23.50), you then could have bought back the previous shares at a lower price once again. And then sold them when the price headed back up.
How to scale trade successfully.
Scale trading can be a very simple way to turn a profit from trading range-bound stocks. But it doesn't always work.
Some companies have overvalued stocks that are prone to crash at any moment. If you try to scale trade them, you will end up buying more and more shares as the price collapses. And eventually, you'll just run out of money.
So here's a few tips to avoid scale-trading the wrong stock.
- Make sure the company you scale-trade doesn't have a lot of debt compared to its physical assets.Companies with high levels of debt might collapse in value. But companies with low or zero debt are much less likely to have that happen to them.
- Only scale-trade stocks of companies you know have a good business model.Don't scale-trade stocks whose products you're not familiar with. And if you know about them but believe their products are junk, don't scale-trade them either. You don't want to be holding their stock when their customers figure out they're getting ripped off.
- Go for low-priced stocks.It can be hard to follow #1 and #2 above and still find a low-priced stock to trade. But this strategy really works best with stocks that are priced at $25 or below. This is because larger stocks have price movements that are too small to make this strategy very profitable. So concentrate on finding the lowest priced stock you can that is still of a high-quality company.
Trying to trade a range-bound market can be frustrating. But follow this scale-trading strategy to make the best of it.