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Scaling in and/or out


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  #1 (permalink)
 
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 Small Dog 
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Scaling in, in creasing the position as it gets more profitable. Scaling out, taking partial profits as the position is making profits. There are probably more proponents of scaling out, but enough defenders of the former to wonder.

What are the thoughts of the brethren? Do you guys scale in or scale out? Or fixed position per trade?

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 doyalalexander 
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My thoughts... When I am looking for a position to hold over time, I like to scale into trades on pullbacks and increasing my average price. Over a longer period I am expecting some ebb and flow. But for shorter trades, especially intraday, I prefer to enter and scale out to lock in profit and breakeven quicker.

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 SMCJB 
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My thoughts...


SMCJB View Post
Why you should add to winners and never add to losers

I recently got an email from Kevin Davey of KJ Trading, aka @kevinkdog, regarding his latest blog post entitled “Peel Off Trading”. Kevin is a highly respected member of nexusfi.com (formerly BMT) who has done several webinars, has his own “ Ask me Anything Thread", has written a book “ Building Winning Algorithmic Trading Systems, A Trader's Journey From Data Mining to Monte Carlo Simulation to Live Trading” and is also I believe the current coordinator of “ The Battle of the Bots".

The basic concept of “Peel off Trading” is
In its simplest form, the trader starts out with 2 contracts, exits the first at a small profit (the “peel off”), and then holds the second as a “runner,” going for big profits. In some cases when the first contract is exited, the second contract is then modified to have a breakeven stop.
Like almost all of Kevin’s work it’s a very interesting piece based upon supporting analysis. Kevin actually back tests the exit rules upon three different strategies but the results are inclusive
Results of the out-of-sample analysis are mixed. The ES is the same, the GC strategy is better with the “peel off” method, and the JY strategy is better with the baseline (always trading 2 contracts).
While reading it I was actually reminded of a different blogpost “ Does [AUTOLINK]Averaging in[/AUTOLINK] Work?” by Ernie Chan. While I don’t believe Ernie posts here he has done several webinars. He has also written two books “ Quantitative Trading: How to Build Your Own Algorithmic Trading Business” and “ Algorithmic Trading: Winning Strategies and Their Rationale”.

While Kevin’s blog was looking at exit scenario’s, Ernie’s blog was looking at entry rules. It was also more theoretical in nature, but his conclusion was more decisive.
Ron Schoenberg and Al Corwin recently did some interesting research on the trading technique of "averaging-in". For e.g.: Let's say you have $4 to invest. If a future's price recently drops to $2, though you expect it to eventually revert to $3. Should you
A) buy 1 contract at $2, and wait for the price to possibly drop to $1 and then buy 2 more contracts (i.e. averaging-in); or
B) buy 2 contracts at $2 each; or
C) wait to possibly buy 4 contracts at $1 each?
Let's assume that the probability of the price dropping to $1 once you have reached $2 is p. It is easy to see that the average profits of the 3 options are the following:
A) p*(1*$1+2*$2) + (1-p)*(1*$1)=1+4p;
B) 2; and
C) p4*$2=8p.
Profit A is lower than C when p > 1/4, and profit A is lower than profit C when p > 1/4. Hence, whatever p is, either option B or C is more profitable than averaging in, and thus averaging-in can never be optimal.
As I started thinking about Chan’s analysis I didn’t like the way he considered the one situation “that the probability of the price dropping to $1 once you have reached $2 is p” and excluded other scenario’s. In a moment of boredom I decided to expand Chan’s analysis to a binomial tree where we have a probability p of going down $1, but also a probability (1-p) of going up $1.

Hence at time T+1 we have probability p of trading $1, and a probability (1-p) of trading $3. Then at time T+2 we have probability p*p of trading $0, a probability 2p(1-p) of trading $2 and a probability of (1-p)*(1-p) of trading $4.

For those of you were not aware this is what we would call a binomial tree which is used to derive the Binomial Distribution ( Wikipedia, Wolfram Mathworld) and there are many option and derivative pricing models based upon binomial trees and even more based upon other type of trees.

If we consider as an example scenario A) where we buy 1 contract at $2, and wait for the price to possibly drop to $1 and then buy 2 more contracts.
In case i) where the market goes up at T+1, and T+2 to $4 we never buy the additional contracts, hence we buy a single contract at $2, that has a $2 profit. Since this has a probability of (1-p)*(1-p) the expected payout of case i) is 2*(1-p)*(1-p)

Case ii) the market goes up at T+1, and then down at T+2 to $2 we never buy the additional contracts, and we have no profit. Hence the expected payout of case ii) is 0.

Case iii) the market drops at T+1, and then rallies back to $2 at T+2. In that case our initial contract purchased at $2 is breakeven, but when prices dropped to $1 at T+1 we added two more contracts. These two contracts now have a total profit of $2. Hence the expected payout of case iii) is 2*p*(1-p).

Finally in case iv) the prices drops at T+1 and T+2 and ends at $0. In this case we lose $2 on our initial one contract purchase and lose an additional $2 on our two extra purchases at $1. Hence we have a total loss of $4 and an expected payout of -4*p*p
Adding this all together our expected payout for scenario A is
2*(1-p)*(1-p) + 0 + 2*p*(1-p) - 4*p*p = -4p^2 -2p +2
It follows that the other expected payouts are B (-8p +4) and C (-8p^2 +4p)

If we plot these functions we can see that while A) and C) might outperform B) (well actually lose less) when p>0.5 (ie market is more likely to go down) but they underperform even more when p<0.5 and hence the expected returns of A) and C) are both negatively skewed in relation to B).


While this doesn’t completely agree with Chan’s analysis that’s it’s never better to scale in, it does support his analysis in that from a risk reward perspective it’s never better to scale down into a position.
I then added a fourth scenario D) where we Buy 1 at $2, and if prices go up we buy 2/3rds more at $3. I know fractions make it messy but it’s the only way to keep it an equal investment size.
The expected payout of D) is +1.33p^2 - 6p +2.67

This is the complete opposite of A) and C). It underperforms 2) when p>0.5 but outperforms by a greater margin when p<0.5, hence it has a positive expectancy skew!

This would imply that not only should you not “average down” but that adding to winning positions has a better risk reward.



While D has the best risk/reward it does have a lower reward than the base scenario B). Hence to achieve the same desired results, you can/should scale the positions appropriately. This is actually a great way to visualize what we are discussing as you can see below. You will see that while 3 of the 4 have similar positive profiles, scenario D has the least worse profile when the market goes against the position.



I then expanded the analysis significantly, going out to T+5, and including additional scale in scenarios. The conclusions were the same though. Averaging down has a worse risk reward profile than buying your entire position at entry, while adding to winners has a better risk reward profile.

Disclaimers/Notes/Flaws/Weaknesses:
A couple of the obvious flaws of this analysis are
- it uses a fixed price movement of $1 as opposed to a percentage move - while this is actually easy to fix for the purposes of this example it would add undue complication since +1-1=-1+2 but +1%-1%<>-1%+1%
- it assumes a binomial distribution when in reality a log normal distribution would be a better fit.
- Price (changes) in reality are not log normally distributed. As we all know tails are a lot lot fatter.
- Stops could potentially completely change the analysis.


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I swing trade equities
I both scale in and out.
I never average down. I enter with a partial position which keeps the risk low and add to the position as the trade moves in my direction.
I exit on a trend line break. (depends on price action) I'll exit 1/2 the position on a trend line break or even possibly sell into strenght on a parabolic move. Take off 1/2 again on a break of a ma and the rest on a break of a higher ma.
This allows me to keeps my losses small and let my winners run. (in theory at least)

"The days when I keep my gratitude higher than my expectations, I have really good days" RW Hubbard
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 Tymbeline 
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I've never "averaged-in"/"averaged-down".

I like adding to winning positions (when I can do so without increasing the risk beyond what it was when I opened the original position) if the "entry criteria" are still at least as valid for me to "add" as they were for me to "open" - and sometimes they are, because my trading tends to be trend-following.

I tend not to scale out, but to "close fully" when I no longer want to be in the trade.

Long ago, trading spot forex, I used to trade 3 lots, closing the first two at whatever profit-level would “cover the cost of the third” and ensure not losing on the overall trade, whatever happened, hoping to catch occasional runners with the remaining lot. I’m not at all convinced, now, that it was the right thing to do.

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 Tymbeline 
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It's now too late to edit my post above, but I forgot to mention that Tharp, Chande and other authors make the hard-to-contest point very well and clearly in their various books that "all in" at the start, combined with scaling out, if you compare it with the alternative of adding to winning positions (i.e. scaling in as well), is in effect a way of maximizing your position-size when your odds are least favourable.

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 rezak 
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For me, it's all in + all out at once, simple as a mammoth shit
0 psychological pressure that way

From a math perspective, it only makes sense to add to existing positions (the profitable ones) and never scale out. But that does not matter.
The most important thing is that you need to feel yourself with almost no psychological pressure, no matter the style of execution.

Try for a week in that way, another week in another way and the market will tell you what is yours.

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 Small Dog 
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This is a really interesting topic. You have big names on both sides of the fence. For instance, Linda Raschke says go all in and scale out. Tom Hougaard, on the other hand, says you should build the position gradually, i.e. add to the winning trade. I guess it depends on the trading style. The former is good for getting "singles", while the latter is superior if you are aiming at hitting home ruins once in a while.

In theory both approaches make sense to me. However, in terms of risk/reward adding to the winner can be better for trend following systems, as winning percentage is low. So you enter small, thus keeping the initial risk low, but as the trade starts moving in a positive direction you add more contracts/lots/shares while tightening stops for previous entries. There are two big questions with this though. First, how do you add, second, where do you stop? As the trend progresses profit potential decreases, so at least theoretically every addition to the initial position has less profit available to it.

But then you can argue this another way. Instead of adding to the initial position as the trend progresses you can pinch bits of the trend, while increasing the position size with every trade. Much of a muchness, but can have varying psychological effects. For example, if the trade runs up and then retraces it is ok, but if you take profit and then reenter with larger size and it turns out to be a retracement - you get yourself a losing trade and get hurt. Losing some of the existing trade feels ok - you are still in the green, but a losing trade is a losing trade.

This brings us back to the money management topic. Many big traders said that money management is more important than the entries and exits. It makes a huge difference to the profits and capital preservation. The trick is to find a sweet spot: risk large enough to make a profit, but not too large so that you run out of fingernails. For small accounts I think fixed ratio is as close to the Holy Grail as it gets in trading. But then again, this is worthy a whole different thread.

I guess my questions is: for those of you who add to the existing trade, how do you do that? On retracements, at fixed intervals, any other way?

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ursus View Post
I guess my questions is: for those of you who add to the existing trade, how do you do that? On retracements, at fixed intervals, any other way?


Not on retracements, personally (though I suspect that might be a good and valid principle).

I don't add until I've moved my SL to at least breakeven. Then I'll sometimes add a lot if my original reason for entry seems no less valid.

I'm also much quicker to add when ADX is rising, and almost never do if it's falling. (I care more whether it's rising/falling than I do about its absolute level.)

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 Small Dog 
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Right now there are a few interesting things happening in Forex. USDJPY, EURUSD and couple of others are coming off their all time high/low, which can mean a long term trend reversal. I am looking at weekly bars, and the idea is to slowly build a large position.

Slightly off topic. I like the idea of position sizing being dictated by the behavior of the market. Sure, you can just invest equal amounts in various, preferably uncorrelated instruments. This will decrease volatility and therefore will allow you to increase the size of each position. For me it makes more sense to increase the position size according to the performance of the instrument. Or a strategy. If one system on one currency pair is performing extraordinarily you have to increase the position there, rather than distribute the profits among lacklustre performers. In the case of trend following strategy it makes sense to build up the size while moving the stop loss of the previous entry to breakeven.

There is a video on YouTube about a guy who turned $200 to $190.000 in one day. He blew numerous small accounts before. However, this time he managed to catch a strong trend and kept aggressively adding to the position as soon as his margin allowed to do so. I am not a fan of blowing accounts, but this way of trading is pretty much in line with the trend following stats: many small losses and occasional big win. Anyway, pretty fun video to watch in any case. Sorry, for humongous size, I don't know how to make it smaller.


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