Scaling Out of
As with many of my articles, this one may shatter your closely held beliefs,
challenge the current 'status quo', and inspire you to think critically in a
manner that you find uncomfortable. Read on only if you can handle
many of my recent free articles, this one, too, has been mostly written up,
waiting to get 'cleaned up' and published. I have two other articles that I
have discussed elsewhere that were 'in line' before this one. I decided to jump
this one up the priority list because I have been getting questions lately
about the topic, and I have recently seen some posts on it, so I felt I'd
rather get this out there next.
Before we start, let me mention that although the title
refers only to scaling out of trades, the general principals apply to scaling
in to trades also. I neglected to put that into the title because, at this
time, my own work is mostly with scaling out of trades. With that clarified,
Over time I have heard many comments about my work. As I have
discussed here and there I have had people tell me they love all of my work,
except using entry techniques. These are the 'fader' crew, who love to just
take a trade as it hits an area. This isn't the place for me to reiterate my
views on why I require an entry technique for my own 'Trading Plan', as that is
way out of the scope of this article.
My point is that sometimes I get feedback as
to why someone is going to use their own ideas for a certain aspect of their
'Trading Plan'. Generally, I like to point out why I came to develop what I did
for that aspect of the plan. I want people to know what my reasoning is for
coming to the conclusions that I have, so that they can truly understand as
much as I possibly can get them to understand about the underlying principles.
As time has went on, I have had more and more comments about scaling, and that
is what I wanted to address in a 'formal' article.
As everyone likely knows, I like to
point out what I consider 'myths', and present serious food for thought on
various topics. I don't seek to 'prove my point', only to show potential
alternate ways to think about something, and hopefully that will contribute to
people trying to think critically about the things they read, the conclusions
they draw, and the beliefs they hold. Such a topic is scaling in and out of
trades. I didn't realize this when I started writing on the topic, such as in
Kane Trading on: Trailing Stops, and Kane Trading on: Trade
Management, as well as in the free commentary, and so on.
One of the aspects
about scaling is that it has been discussed from the viewpoint of many
'scientific', or should I say mathematical or statistical, studies. Hence, the
conclusions are presented as definitive, clear-cut, or irrefutable. I have
heard many people say things like 'Of all the things you don't want to do, this
one is at the top of the list', and 'Statistically, you will make more money
not scaling out of a position, and this has been clearly proven from studies'.
What does Jim think? I disagree.
Let me mention a few things before we continue. My
background is heavy in mathematics (including probability and game theory),
with graduate work in there. I don't say this to sound like I think I'm
something because of that, or to say that because of that what I say is gospel.
I am simply pointing it out to say that I am not without mathematical skills
when I draw my various conclusions.
Also, I am not going to try to refute the
claims of studies on scaling with studies I have done, or published (note that
most sources mention the studies, but never actually do cite any specifically).
I am going to present some logical food for thought concepts that the reader
can think about, and then draw his or her own conclusions from there. If one
wants to stay with what they currently believe, I'm 100% fine with that. I
simply want to present some other possibilities here.
I am going to cover two main
aspects in this article. The first is a mathematical issue I have with the
studies, and the second is a psychological aspect. In order for me to get into
the mathematical aspect, I am going to digress into an analogy with moving
averages, and hopefully I will be able to make my point as I transition back to
the concept of scaling. Please bear with me as I unfold this
We all know that a moving average crossover 'system' doesn't 'test
out'. What that means is that over time it will not make money, no matter what
parameters are chosen. I don't want to get too far off topic, so I will assume
the reader understands what I mean here. You can choose pretty much any period
in past history and find a choice of two moving averages and create a crossover
'system' that will be profitable, sometimes wildly profitable. This is the
fodder of many dream merchants.
The problem is that there are a nearly infinite number
of choices for the parameters, and perhaps only a few will 'work' on that data
set. You change the data set and another set of parameters will 'work'. There
seems to always be a few sets of parameters that will 'knock the cover off the
ball', but the reality is that you can never know which few, of the many, it
will be until after the fact. This makes it nearly useless information for the
practical trader. Very interesting that there is a set of parameters, but next
to useless for me.
Now, how does this relate to where we are going right now? I am
going to make a bold leap here that will make many people uncomfortable. I
can't 'prove' what I am about to say, I am simply going to state my opinion,
based on my experience with mathematics. Feel free to disagree if you want.
Although I agree that there surely is a technique to close a position in one
shot that would show more profit, used solely by itself, than any scaling
technique, I contend that you can never know what technique that is until
after the fact, just like a moving average set of parameters. Wow, that has
Now, think about this for a minute. The entire basis for abandoning
a scaling out approach is because mathematically it is not as efficient as a
non-scaled approach. But the studies that 'prove' this have the ability to use
hindsight in formulating the study. They take a data set, and then test various
scaling techniques and compare them to one non-scaling technique, and they fall
short every time. I don't dispute that mathematical observation. But what has
that got to do with trading reality? I contend it has very little to do with
have no way to know, as markets change, and various market conditions present
themselves, what the optimal single technique is, am I not in about the same
boat as trying to use a moving average crossover 'system'? I have seen people
discuss in various places ideas about how the market, at a given time, may be
in various 'phases', like trending, sideways, doing these with or without
volatility, and so on.
They discuss how one might change their techniques based on
observing the current conditions. This doesn't even take into account a greater
market condition that changes over time, as these various 'phases' exert
themselves, like the effect of increased program trading or hedge funds, and so
on. If one could know what 'phase' the market was in early on, one could use
the plan that works best for that. But there is a problem.
This sounds to me
exactly like the idea that one could just adjust the moving average crossover
parameters to the ideal as soon as the market condition was known. Uh-huh, that
will work. Sure. If that would work, the whole program trading world would do
it, and arb out the edge. Back to the drawing board. I contend you will never
be able to use that approach successfully.
What does this imply, to me? That the studies
that rip up scaling out are nothing more than a mathematical curiosity to me as
a practical trader. I will now move towards my explanation of why I think
scaling has merit. I was listening to a discussion the other day about how this
person had four 'systems', and they were each tuned to a different 'phase' of
the market. He never knew what phase the market would be in, so he ran all
four. When he tried to second guess the market 'phase' he was usually wrong, or
late. His best real world results were from running all four.
I saw an analogy
here with the idea of trading various commodities so that while one is in
drawdown the odds of others not being in a drawdown were pretty good, and hence
the equity curve was smoother. Yes, it would be the most efficient to trade
just one issue when it was not in a drawdown, but good luck knowing what issue
that is. And good luck knowing which 'phase' the market is in in time to make
use of that, good luck choosing the right moving averages, and good luck, too,
knowing which single technique is the best one to take off your entire position
realized I didn't know which 'phase' the market was in, and which of my
techniques was best at a given time. So, for the sake of this example, let's
say I found four techniques, and each seemed to work best during a different
'phase'. Before we continue, let me mention that I am not strictly referring to
four actual market phases, as I briefly outlined above, since I don't look at
the market like that at all. I simply am trying to demonstrate that the market
changes, and behaves differently throughout the day, and from day to day, and
year to year. I simply can't tell in time what type of behavior it may have
when I enter a trade.
If I trade all four techniques at once I perhaps get the benefit of
smoothing out my equity curve, and although not being as efficient as having
only the best technique on at that time, that's immaterial, since I can never
known which technique that will be. To apply this to scaling, let's say I am in
a single trade, using a single setup and such up to that point, but then I
break it into four scale outs. Each is an independent technique, and is
triggered by different factors in market price action. In the real world I feel
this will outperform choosing any single technique for exiting.
So, can I back that
up with studies? Absolutely not. As I have said many times, what I do is
discretionary, and could never be 'coded' or 'back-tested'. I'm not even saying
what I just presented is, in fact, better. I'm just saying I believe it to
be, and that it is not so cut and dried as some very oversimplified studies
make it sound. I'm not saying discount the studies, I'm just saying they aren't
irrefutable 'fact' like they many times are presented to be. I am trying to
show there may be another side to this, and hopefully people will start to
think about that.
Now, before we move on the the second point, let me get into a
little detail on something. Mathematically it might be argued that if one did
choose a single technique, and just ran it regardless of the 'phases' of the
market and the idea that it may be great at times, and poor at other times, it
would perform equal to the blended technique I mentioned. I'll grant that that
may be close to true. But, and I find this a big but, the drawdown should be
greater, for reasons cited already about what blended trading of issues and
systems have shown.
All thing being equal, I'll choose the smoother equity curve, not
just for the psychological reasons, but also for the mathematical reasons that
if an account is drawn down, it is harder to recover from than one that doesn't
have that drawdown. And on top of this, the argument from the single exit
people is that it is superior. The best real world argument I can see is that
it might be equal with greater drawdown, which, in my opinion, makes it quite
Finally, we get on to the psychological issues. I recently saw a
post that basically said the only reason to scale was to make one feel better,
and they only would do that because they were psychologically unfit to trade,
weak, wimpy, and so on. Well, let's jump from theoretical to real world here.
Maybe this person was a 100% robot, able to execute perfectly under all manner
of pressure, but most of us aren't. We are human, filled with frailties and
Sure, it would be ideal if we could all simply not trade unless we
could be machines, and operate at 100% efficiency, but that is not the real
world. Are doctors or airline pilots at 100%, 100% of the time? Are you kidding
me? This is a real world, filled with real people. Just because I can't operate
100% without any emotional realties to contend with doesn't mean I shouldn't
trade, or be in business, or hold a job. Get real.
The point here? What if I had a
choice between a methodology that makes me an x% return for the year, but
because of my psychological makeup stresses me endlessly. Or I could use
another methodology that returned me .90 x%, but I was very comfortable and
efficient with it. It suited my personality, and my realistic human
limitations. Hmmm, would I be weak if I chose the latter? In my opinion I'd be
acting very smartly. People are human, and the best 'Trading Plan' is not
always only chosen simply because the rate of return is the highest of all
variations of the plan. And it in no way implies that there is anything 'wrong'
with a person who chooses such a plan.
Now, how is this directly relevant
to this topic? Well, what if a blended, scaled approach yielded a little less
return, but had a much smoother equity curve, with less drawdown, and a person
decided to choose that because the lesser return was a great trade-off with the
much higher comfort level? Mathematically (using the studies, not what we have
covered today), this makes no sense, right? Well, not accepting who you are and
what works for you is a sure way to failure or burnout, and mathematically zero
return isn't too good. Not taking into account the human factor, or saying only
wimps would take it into account, is no way to proceed if you want to succeed
at this long-term, in my opinion.
So, what do you think? Are you thinking now? I've
developed quite a reputation, one which I am very happy about, for presenting
the other side of many issues. I don't like biased or one-sided presentations.
I don't care what people decide, and I have no axe to grind, I just want people
to see both sides so that the decision they make is informed. We have far too
much one-sided information out there, and far too many people citing studies
and ideas and not blending in common sense. The emphasis on 'scientific' is so
great it supersedes the use of critical thinking and common sense.
I know this is
controversial, and many want to just stick to the numbers from oversimplified
studies. Heck, don't you recall the studies that 'proved' the market is random?
Where are they now? I've been down the academic and 'scientific' road, and I'll
take, personally, critical thinking and common sense over 'studies' any day of
the week. I'm not asking that everyone do that, only that you at least look at
what the other side looks like when you make your assessments in the real
world. If I have convinced people to do that, this time here was well spent for
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