Before I get too deep into this, I have some disclaimer/warning stuff to cover. You should know already that you always trade at your own risk. The trade belongs to you, and no one else. I'm not telling you to scale in on every trade, nor am I suggesting that you should at all. Plenty of traders make plenty of gains and never scale in or out. I've been asked to incoporate my scaling habits into a post. This is to honor the request of this topic.
Scaling In
Scaling refers to a somewhat systematical and strategic approach of getting in or out of a position in sequential phases instead of just all at once. Those phases are defined by share or dollar increments all the way up to your maximum investment in the trade.
Although this method definitely appeals to traders that prefer not to just jump in (or out) of a trade with both feet, it will increase your commission costs (as every add and exit is commissionable). This will likely reduce your gains and could impact your tax liability. This strategy takes time and experience to master, and in my opinion is truly a strong point in a successful trader's strategy.
The key to using this approach is risk management. Its easy to just add and add and add... but if you add the same amount of shares (or less) for each add, you will likely hold far less shares at an average that is more relative to your initial entry. Adds get expensive, and can end badly if you're not careful. Know when its too much, and when to get out.
Going Against the Grain
Most traders would tell you that you never add to losing trades. Personally, I disagree with that statement for the benefit of my own trading style. I've made a lot of money adding to losing trades. I've been called unorthodox, people call me crazy and say I have huge balls... but every move is calculated to work in my favor. I likely see something that they don't see. Again, its your trade, no one else's. Every trade, keep your emotions low and influence at zero. Let nothing phase your read on the chart.
I have conviction in my trade, or I wouldn't be adding more shares to my position with each entry. The main benefit of scaling is that it allows traders to increase or decrease the average entry price for the position in their favor. As a result, it offers traders a beneficial approach when price action moves against them.
There isn't much benefit to your average when adding anything less than 100% of the shares you already own to a losing trade. However, if you were to add larger amounts each time, you can sway your average heavily in favor of your largest add, thus increasing profits substantially when the price turns in your favor as you anticipate that it will.
Typically, I add when price action is working against my original entry. For example, if I spot a rising wedge and I'm confident in the pattern, I may enter a short trade at any time. From that entry, I will add all the way to the top, with my largest adds coming at what I believe to be the top, as well as the retest, should one occur. With each add, my average climbs higher, increasing my profits once/if the wedge breaks to the downside. This is demonstrated below on $RJET:
Account Size
Adds are obviously limited by your account size as well as your free cash for trading. So again, caution should be considered before considering a scaling strategy. For those with larger accounts, you could potentially say the absolute maximum you're going to trade on this stock is $65,000, and initially enter with only $2,000. Even if you doubled your position with every entry, you would still have ammo for 5 adds.
Pyramid Strategy
Lets say you see a huge run up on an earnings winner. You watch as the price continues to climb. Rookies may chase this depending on when they spot the move. If a move is a "whoa" to look at, you're probably too late to catch it. If you wait for the top, and are trailing the move using your Fibonacci tools, you can set potential adds at each fib level of the expected retracement (the same strategy can be flipped upside down using fib extensions for a short play on a push move).
Because the stock is an earnings winner, it could potentially retrace and extend another leg (potentially more) up before ultimately consolidating at a new level. Additional opportunities may present themselves regularly with larger patterns as well, such as a wedge where price action is pinging up and down from support to resistance. Believing that the price will ultimately go higher, you could either take a chance in shorting the retracement, or go long in an attempt to catch the second move.
With a long trade, an example of the pyramiding strategy would be an initial entry at the .238 level of 100 shares, followed by your first add at the .386 with 200 shares. The next ideal add level is the .5 fib with twice as many shares as your last add at 400 shares, and your final add coming at the .618 with 800 shares. This strategy creates a "pyramid" shape in the size of your adds with the biggest add at the bottom, and the smallest at the top... essentially leaving your average much more on the low end of the pyramid. The idea is always to add more than 100% of your position, which will always result in a pyramid shape.
This is another example of a scale in trade, with an earnings winner pullback. This price action is part of an extension (push) from a long retracement (pull). During such a move, I can tell by fib measurements where my best entry points are, as illustrated below on $AMZN.
In total, you've purchased 700 shares with a low average on the retracement. Sure, you could have set a buy order at the .618 and purchased all of your shares at that level, but as you can see, the price only dropped to the .5 level. It never would have retraced far enough to get the order filled. Even if it did, who is say that all 1500 shares would get filled? Using the pyramid strategy on this sort of trade is the safest way to get the maximum shares for your invest at the best potential average.
The same strategy can be applied to short trades with both the charts and the pyramid flipped upside down, and your largest adds coming at the top with your smallest at the bottom.
If you have the ability to do so, you can add as many shares as needed to increase or decrease your average to a specific price level. I have been known to do this on trades that extend further than I had anticipated. As a result, I can turn a potentially losing trade into a winning one once the price does turn in my favor as I had originally expected it to.
Why I Don’t Scale Out
I don’t scale out, and I wouldn't recommend that you do either. I personally think that in most situations, scaling out isn't the way to close a trade. Of course there are exceptions, like dumps that could just keep falling. In a few situatuons it does make sense to take scale out profits at potential support or resistance levels.
However, when you scale out you take partial profits on your full position as price action moves in your favor. Sounds nice. The problem is that you are limiting your maximum gains on a winning trade. You want to maximize winning trades, not minimize them. Essentially, by scaling out you are purposely limiting a winning trade.
When you scale out, not only are you cutting down your position size as the trade becomes more profitable, as the trade moves you may be holding the least amount of shares at the most profitable part of the trade. You may also only partially cover to find the price push higher, and higher. Doesn't sound like "letting your winners run" to me. Trading is about maximizing your gains and cutting your losses before its too late. Just my thoughts on the matter.
Conclusion
Again, the above mentioned methods are recommended for advanced traders only. Even then, most traders would not advise you to add to losing trades, and to winners only (in an attempt to stack shares before closing the trade.)
Scaling can benefit you greatly if mastered. Once again, inexperienced traders should use caution when attempting to scale in and out of a position. It isn't for everybody. If you're not sure the price will turn, or you don't have conviction in your trade, don't scale in... get out.
Labels: Trading Strategy
