In this chapter, we will focus on an interesting aspect that can be used in trading: Scaling in and scaling out of your positions.
When the price approaches a support, it is difficult to say at hindsight whether it will break the support (warranting a sell) or whether it will hold the support and reverse (warranting a buy). The opposite is also true when the price touches a resistance. Furthermore, once a support or resistance is broken or held, there could also be some doubts regarding its validity. All these concerns are quite genuine and something that every trader frequently faces when he or she wants to make a trading decision. So, the question that could arise is how to validate a trading signal?
There are a few parameters that could be used to determine the validity of a support or resistance breaking/holding. Some of them are as mentioned below:
- Volume filter
- Points/percent filter
- Closing price filter
As an example, if a particular support (resistance) breaks and if that break is accompanied by an expansion in volume, the break is likely to be more reliable than if it were accompanied by a contraction in volume. In such a case, one could create a short (long) position, after establishing the stop loss and the target level and ensuring that the reward to risk ratio is attractive.
Similarly, if a particular support (resistance) breaks, one way to gauge the validity of that break is to wait for the price to close below (above) that support (resistance), before deciding to act. Occasionally, what happens is there is an intra-period break but by the time the candle/bar closes, the price reverses and closes on the opposite side of that break. What we have here is a false intra period break.
In the above chart, notice the two false breaks above resistance. As said earlier, one way to avoid such false signals is to wait for price to close above the resistance, before initiating a trade. While a close above resistance does not guarantee that the break will be successful, it nonetheless enhances the validity of the break, especially if it is also accompanied by an increase in volume. Later in the chart, see that the price closed above this resistance, turned sideways for a few candles, and then started trending higher. Notice how volume picked up as price started rising following the consolidation.
Above, we talked about the dilemma that exists when entering a position and also spoke of some ways in which this dilemma can be reduced. A similar such dilemma could also exist when exiting a position, either at a profit or at a loss. As an example, once you are in a position, if the price approaches your take profit level but the prevailing trend still looks healthy, you may face a dilemma of whether to exit the position and book profits or to continue holding the position and revise the targets.
Let us understand this from the point of view of buying on a breakout above resistance.
At the time when price is breaking above resistance, there is a great deal of uncertainty as to whether the break will turn out to be genuine or false. Now, there are advantages and disadvantages of entering at the breakout level. The advantage is that if the breakout turns to be genuine, your profit potential could be high as you will be entering the entire position early and at a single price - the breakout price. The disadvantage is that if the break turns out to be false, you will get whipsawed on the entire position and may have to exit the entire position at a loss.
On the other hand, waiting for price to close above resistance before entering a trade also has advantages and disadvantages. The advantage is that it is a conservative and a safer strategy, as you would have a confirmation of the break. The disadvantage is that if the break turns out to be genuine and price ends up closing significantly above resistance, you could miss out on a part of the move and end up buying all the shares that you intended to buy at a much higher price, a move which could make the reward to risk ratio less attractive.
As you can clearly see, there is a trade-off between buying at breakout versus waiting for a close above breakout before buying. How can one tackle this situation?
One way to reduce this entry/exit dilemma is to deploy a technique called scaling in and scaling out. In this section, we will focus on scaling in. What does it mean to scale in? Well, put it in the simplest of words, scaling in means entering a position in tranches and at different prices rather than entering the entire position at one single price. For instance, let us highlight a part of the earlier chart.
Let us assume that a trader was keeping his eye on the high that is on the extreme left of the above chart. He intends to buy (for the short-term) 100 shares of the stock above this high. As there is a great deal of uncertainty at the time of breakout regarding whether the breakout would be genuine or false, one way the trader can tackle this dilemma is to scale in. That is, buy half the quantity (or in any other proportion, depending on conviction) at the breakout level and the rest on a close beyond the breakout level. This way, if the trade turns out to be right, his entry price would get averaged out and he would also have a breakout confirmation from the price. On the other hand, if price fails to close above the breakout level, moves lower and hits his stop loss, he will suffer only half of the losses. Eventually, see that the break turned out to be false and the position got stopped out. But by scaling in, the trader only bought half the intended quantity and did not buy the rest as the price failed to close above the breakout level. As such, his loss is limited to the extent of just 50 shares (instead of 100 shares).
Above, we explained from the point of view of buying on a resistance break. This concept of scaling in could also be applied to the below scenarios in addition to the one discussed above:
- Buying at or near support
- Selling at or near resistance
- Selling on a support breakdown
Above we talked about scaling in when entering a new position. Scaling in can also be done when a position has already been established and the trader is either making a profit or suffering a loss. In this section, we will focus on the former i.e., scaling when adding to an existing profitable position. Let us assume that a trader has bought Nifty futures. The details of the trade are as mentioned below:
- Entry Price = 15500
- Stop loss = 15300
- Target = 16000
- Quantity bought = 1 lot
- Lot size = 75
- Risk = ₹15,000 ([15300-15500] * 75)
- Reward = ₹37,500 ([16000-15500] * 75)
After entering the position, let us assume that Nifty moved higher and is currently trading at 15800. The trader is now making an unrealized profit of ₹22,500. He is interested in adding 1 more lot to his existing position and trail the stop loss higher on his old position to 15700. He also intends to keep the same stop loss for his new position. Because he has added a position at 15800, his average buy price has moved higher to 15650. In case the market reverses and Nifty hits his stop loss, his first trade would make a profit of ₹15,000 but the second trade would realize a loss of ₹7,500. Still, see that he would make a net profit of ₹7,500. However, what if Nifty does not hit his stop loss of 15800 and instead goes on to achieve his target of 16000? Well, in that case, his first trade would make a profit of ₹37,500 and his second trade would make a profit of ₹15,000, increasing his overall profit to ₹52,500 (instead of the original intended profit potential of ₹37,500).
Just as there are advantages and disadvantages to scaling when entering a new position, there are advantages and disadvantages to scaling when adding to existing profitable positions as well. The advantage is that your profit potential can shoot up in case your view goes right. The disadvantage is that your profit potential could decline, and, in some cases, you might even suffer a loss in case your view goes wrong. Keep in mind that by scaling in, you are essentially increasing your exposure, which in turn would increase not only the profit potential but also the risk. Hence, you need to closely look at the reward to risk picture before deciding to scale an existing profitable position. As an additional suggestion, whenever you decide to scale in an existing profitable position, trail the stop loss on the old position in such a manner that even if the new stop loss were to get hit, you would still end up making money rather than suffering a loss. We illustrated such a case in the Nifty example above.
Compared to the two scale in strategies that we have discussed so far, this is a very risky strategy. This is because, under this strategy, you would essentially be averaging your losses. The risk is that if price continues moving against your position, the losses could very well amplify, as you would be holding multiple quantities of a security. Hence, scaling to your existing losing position must be done only if you have a very strong conviction on your trade and you can tolerate the losses if things do not go your way. Let us understand this using a hypothetical example. Let us say a trader has shorted Nifty futures. The details of the trade are mentioned below:
- Entry Price = 15900
- Stop loss = 16100
- Target = 15500
- Quantity sold = 1 lot
- Lot size = 75
- Risk = ₹15,000 ([15900-16100] * 75)
- Reward = ₹30,000 ([15900-15500] * 75)
After entry, let us say Nifty starts rising and climbs to 16000. Seeing that Nifty is now trading at a psychological level, the trader decides to sell 1 more lot of Nifty at 16000, maintaining the same stop loss and target. This would raise his average selling price to 15950. Going forward, if Nifty continues rising and hits the stop loss, the trader’s total loss would amount to ₹22,500. See that his loss has increased more than he had originally expected, for the simple reason that he averaged a losing position and the view still turned out to be wrong. The only saving grace here was that he had a stop loss in place, thereby capping his losses. For this reason, stop losses are an absolute must, as they help limit your losses. Moving ahead, what if instead of rising towards 16100, Nifty started declining and fell to the target of 15500? Well, in that case, the trader’s total profit would amount to ₹67,500.
When you are averaging your losing position, you must thoroughly understand what you are doing and must ensure that the decision taken is not based on emotion but rather on your conviction. You must also ensure that the total risk you are taking is well within your limits and will not have much of a negative impact on your trading capital.
Scaling out is primarily done with the objective of reducing your existing trades and thereby reducing your exposure to risk. The objective could be to either lock in some profit (if you are in a winning trade) or reduce the losses (if you are in a losing trade). Let us understand this concept using a hypothetical example. Let us say a trader has bought a stock. The details of the trade are mentioned below:
- Entry Price per share = 500
- Stop loss = 470
- Target = 575
- Quantity purchased = 100 shares
- Risk = ₹3,000 ([470-500] * 100)
- Reward = ₹7,500 ([575-500] * 100)
At a price of ₹550 per share, the trader is making an unrealized profit of ₹5,000 ([550-500] * 100). The worst scenario that could unfold going forward is the price of the stock unexpectedly declining and going all the way to hit the stop loss of 470. In this situation, the trade would go from an unrealized profit of ₹5,000 to a realized loss of ₹3,000. After all, you never know when the tide will turn against you. That said, you can take steps to ensure that you are not caught off guard.
When your position is comfortably profitable, it is always a wise idea to either trail your stop loss in the direction of your position (i.e., higher for a long position and lower for a short position) or scale out of your position (i.e., partially close your position at a profit and keep the rest open) or a combination of the two. In the above case, because the RRR had exceeded 1, let us assume that the trader decided to book half of his position (50 shares) at 550 (profit of ₹2,500) and keep the rest open by trailing the stop loss higher. Based on chart analysis, let us say that the trader sees a support at 543 and decides to revise his stop loss on the remaining position to 540. Going forward, if the price advances from 550 to 575, the trader could either book profit on the remaining position or revise his stop loss and target higher depending on his view and conviction. In this case, let us assume that the trader booked profit on the remaining position at 575 (profit of ₹3,750). So, he has earned a combined profit of ₹6,250 (₹2,500 + ₹3,750) on this trade, earning a return of 12.5% on capital deployed.
Had the trader not booked part of his position at 550 and had he instead booked the entire position at 575, he would have earned a return of 15% on capital deployed. This is a disadvantage of scaling out - your maximum potential profit reduces. However, the key advantage of scaling out is that risk reduces. And if done appropriately, you could even eliminate potential losses. For instance, in the above case, had the trader not booked part of his position at 550 and had he not revised the stop loss higher, he would have suffered a loss of ₹3,000 if the stock had reversed from 550 and hit his stop loss of 470. On the other hand, by booking part of his position at 550 and trailing the stop loss to 540, the trader would have still made a net profit of ₹4,500 (₹2,500 + ₹2,000), even if the stock had hit his trailing stop loss. Notice the difference between the two highlighted regions? This is a major advantage of scaling out.
After buying the shares at 500, let us assume that the stock moved lower to 485 and started consolidating near that region. Now, let us assume that the trader no longer feels as confident about his position as he felt at the time of entry. Based on this, the trader decides to close half (50 shares) of his position at 485 (loss of ₹750) and keep the rest open. Going forward, if the stock continues declining and hits the stop loss, he will exit the remaining position (loss of ₹1,500). So, his combined loss is ₹2,250 (₹750 + ₹1,500). See that by scaling out, his overall loss potential has reduced (the original risk was ₹3,000). The drawback is that, after exiting half the position at 485, if the stock moved higher and eventually hit his target of 575 (profit of ₹3,750), his total profit will reduce to ₹3,000 (₹3,750 - ₹750) (see that the original expected reward was ₹7,500).
As you can see from our discussions in this chapter, scaling has both advantages and disadvantages. Make sure to assess both the pros and cons before implementing a scaling strategy.
Position Sizing6 Lessons
In this chapter, we will talk about a critical aspect of money management in trading, called Position Sizing.
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