Trading 101- Scaling Entries and Exits

[Mr. Now]

Trading 101- Scaling Entry and Exit

Ask anyone who has traded for awhile and they will tell you the exit is more important that the entry. If you have a good method, both exits and entries can increase favorable odds for profit-- via scaling.

Scaling is the process of buying pieces of a total position as price moves. For example, you may have a method of buying a certain stock if/when it reaches a key area of support such the 50 or 200 day moving average. Instead of buying all of the position in a single buy, you make several smaller purchases.

A typical way to buy into a trend is to wait till the trendline is threatened, and buy at the trendline.

Often, getting the entry right can be tricky since price can and will bounce anywhere from 2% above to 3% below the 50 or 200 DMA.

Often you have the right idea but do not fill because your price is too low, perhaps right on the 50DMA but price approaches from above and then bounces higher from above, never touching the 50.

A much more common scenario is to enter just 2% or so above the 50 and then watching in horror as price violates the 50 and penetrates by 2% or more. Now your protective stop is hit intraday and you exit long-- at the low of the day. This common ailment is known as ‘trader’s disease’.


Level Scaling

Enter scaling. If you arrange your total buy into 4 buys, you can enter long inside a zone, via a range of prices.

For example, assume the 50DMA for XYZ is at $100 and price is now $103. You might arrange limit orders thus:

100 @ $103
100 @ $102
100 @ $101
100 @ $100
TOTAL 400 @ $101.50

This is an improvement but there are still problems. First you might fill only 100 or 200 of the 400-lot, at realtively high prices. Next, price may continue lower and you are already losing since price is now at $100 and your average is $101.50.

Next you must follow your trade plan and REFRAIN from averaging down. Averaging down is a cardinal sin of trading. Note that scaling is systematic “planned averaging” at entry and exit. This is quite different than changing your plan when the market moves against you, and then deciding to average down. If your plan calls for 400 shares, that’s it. Done. Now you watch the market do what it going to do, and you must honor your stop.

Level scaling has problems, described above. A better way is to observe the personality of the stock and scale in, starting at the boundary of the zone where the stock typically bounces. For example, many trending stocks periodially threaten their 200DMA 3 or 4 times a year, but never quite get there. Instead, price approaches from above and bounces somewhere between 2% and 1% above the moving average. For stocks like this you can define an entry zone that starts 2.5% above and ends .5% above the 200DMA. Many other stocks will habitually penetrate the 200DMA by 1 or 2% and then bounce hard. For stocks like this the zone starts at 1% above and ends 3% below the 200DMA. You must know the stock to be able to find the zone.

Skewed Scaling

When you have identified the zone AND developed patience, you can try skewing your scale such that you get the most stock at the most advantageous prices. It works like this:

XYZ’s 200DMA is at the $100 level. XYZ is trending and does come near the 200DMA from time to time. When it does, you notice is almost never reaches the 200 before bouncing. In the last 2 years XYZ has come within 1 to 2% of the 200DMA 6 times and it touched the 200DMA only 2 times. The other 4 times it bounced well above the 200. You can use that.

You arrange buys as follows:

050 @ $103
100 @ $101.25
250 @ $100.50
TOTAL
400 @ $101

Now your average price is very close to the current price, and the likelyhood of an immediate bounce is high. If price bounces before you fill the last 250, you have small size but are still showing an immediate profit.

Accordingly the trade tends to go good from the start no matter what-- if it bounces. You have an immediate profit and away you go. Now you follow the trade plan.

If there is no bounce, you are still OK. Because the scale-in is skewed towards the lower prices at the extreme lower area of the buy-zone, you have great risk reward characteristics as defined by stops. You can set a very tight stop. For example you may calculate that if price goes below the 200DMA by more than one-half percent (.005) there is an 80% chance you are wrong. Hence you can set a stop that is 1/2% below the 200DMA, at $99.50. Your risk is now:

$101 - $99.50 = $1.50 per share (plus any slippage)

If you expect XYZ to bounce to at least 3X your risk, you have an excellent trade in the works. You can often find situations that are 4,5 or 6X the risk if you are willing to learn the personality of the stock and engage in some skewed scaling.

Note that 3,4,5 or 6X the stop is easier to achieve if the stop-defined risk is small. If you have a wide stop your profit objective must be quite a bit higher-- and less likely to be realistic and achieveable.

The same scaling techniques can be used for scale-out exits near zones of pivotal resistance. Acceptable exit and entry prices are typically not precise numbers. Rather, good prices for entry and exit are values within a fairly narrow zone defined near a pivotal support or resistance point.

The same scaling techniques can be used to buy breakouts, sell breakdowns, etc. Scaling itself is not a trading method but rather a way to extract more profit from a method that already works.


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[CardMinger]

Great post...

There are many similar methods that accomplish the same goal...the point is have an entry and exit plan and stick to them!

Obviously I think this post should be stickied...

CM

[leto333]

Powerful stuff, I recently read an anecdote about Richard Dennis using this method in his futures trading, buying an initial $100,000 position when his entry signal told him to, only to get stopped out for a relatively small loss time and again.

Finally the trend began and his position was profitable and each time the price dipped to his support trendline, he would add to his position, by the time he begain scaling out of the position it was worth over $100 million dollars.

all you need is risk capital, patience, and discipline. The first is easy if you already have the last two, impossible if you dont.