I know, I know, there’s no such thing as risk-free trading. Risk is inherent in trading – if you want entirely risk-free investments, you’ll have to accept the generous 2% returns being offered on the high street, that can’t even come close to our rising inflation levels.
But what I want to show you today is a simple technique you can apply to your trades that can limit your risk and increase your profits.
It’s to do with scaling …
An exciting trading technique
Some traders swear by this trading technique and use it religiously.
Some traders see it has the investment equivalent of Hari Kari.
As with so many things in trading – the truth is somewhere in the middle. Scaling doesn’t work in all trading situations, and it needs to be done right.
Which is what I want to show you…
What does scaling in financial trading mean?
Put simply, scaling is adding funds to or removing funds from an open position.
Scaling can help you to manage risk, by not over-committing yourself and keeping your stakes low until the movement of a trend has been confirmed. Or it can be used to manage your risk by taking profits early and reducing the size of your position.
Scaling into a position means that you are adding funds to it.
Scaling out of a position means that you are removing funds from it.
You can scale into a winning position, and you can scale into a losing position.
Scaling into a losing position – often called “averaging down” – is a very contentious issue. Why would you want to add to a losing position? It sounds counterintuitive – like throwing good money after bad.
The philosophy is that you are so sure of your trade that you want to snap up as much as you can as cheap as you can. It is something that investors do in buy-and-hold stocks, but really not something that I’d ever recommend in shorter-term trading unless you are very experienced and very confident in risk management.
For most of us traders, averaging down is a short-cut route to huge losses that can overwhelm our portfolio.
So, today I’m going to look at ways to scale into a winning position. This is, in theory, less dangerous than averaging down. However, if it isn’t done correctly, it can also lead you into risky territory.
There are a lot of good reasons for scaling into a winning position.
First and foremost – if we add more money to a winning position, we have the opportunity to make bigger profits.
Secondly, scaling can help us psychologically. Managing five positions each risking £200 can be considerably less stressful than one position risking £1,000.
And thirdly, most of us would be kidding ourselves if we claimed that our entry and exit levels where perfect. In reality, they tend to be approximations – we identify “areas” where we want to enter a trade and areas where we want to get out. Scaling allows us more space for the process of getting our trades “nearly right”.
The obvious pitfall with scaling into a position is that adding funds means adding risk.
In a moment, I’ll show you how to deal with this pitfall, so that you can add funds, without adding risk.
A criticism people often have against scaling is that it suggests that you are “woolly” about your trade in the first place. Scaling in should never been done ad-hoc, because you feel like it – it should be part of your original plan when you enter the trade in the first place.
Another issue with scaling in is that it doesn’t work in all markets. Scaling in works best in a trending market where you are trading with the trend – that way you can increase your profits while riding that trend.
How to build your stake without building your risk
The answer to this problem is two-fold: number one, if you plan to add to a position, start off small; number two, use trailing stops to ensure that your risk never gets beyond your comfort level.
(If you want to find out more about trailing stops, you can check out the Market Maven archive here. [http://www.whatbizopp.com/TradingSystems/news/Do_trailing_stops_really_work_.aspx] Personally, I prefer to control my stop losses manually – but the same theory applies.)
So, if your intention when you open a position is to scale in should it move in your favour, you should start off with a very modest risk percentage.
And, when the price reaches a level at which you want to add to your position, you can tighten up your stop loss, thereby keeping your risk level the same.
Here’s an example of using this technique in a strongly trending market, where we’ve identified a potential 3:1 trade, with a 20-pip stop and a 60-pip profit target …
Here, the profit target was 60pips, and the initial stop loss was 20 pips from the entry level. Once the market moved up by 20 pips, extra funds were added, but the original stop loss was tightened in at the entry level. This happens again when the price has moved up another 20 pips – again adding the position and limiting risk. Profits are finally taken when the market had moved up by 60 pips.
Bear in mind that if you try to scale up in a range-bound market, you run the risk of getting stopped out before you reach your target – in fact, whenever you move your stop loss in, you are naturally increasing your chances of being stopped out.
Here are some key points to remember if you’re scaling into a winning position…
1. If you’re adding to your position on a winning trade, always bring your stop in to control the added risk.
2. Don’t add to a position on a whim – know your stake sizes, entry levels and stop levels before you open the position.
3. Watch for range-bound markets – scaling up works best in trending markets or during strong market moves.
Scaling into trades can be a very successful way to enhance profits and control risk. Many, many experienced traders do this – starting out their positions with minimal risk, and only building on that trade when they have had confirmation that their analysis is correct.
However, it is not something that you jump into without a thorough understanding of the risk/reward ratio on each part of that trade.
Remember – start small and build slowly.