Stockscores.com Perspectives for the week ending July 18, 2010
Scale in to Increase Profits
In this week’s issue:
Strategy of the Week
Stocks That Meet The Featured Strategy
An important skill for traders to master is position scaling. This technique allows you to build a large position in a trade without having to take on a lot of extra risk. It gives you a way to take the most advantage of a trade that is working.
One of my cardinal rules is to never ever average down on a trade. If you buy a stock at $10 and it falls to $9, don’t buy more! Doing so is like betting more on the horse that is in last place mid way through a race.
What if your trade is working? That means that the stock is trading at a price that is higher than what you paid. When conditions are right, add to the position by buying more at higher prices. Averaging up is what scaling in to a position is all about.
Here is an example of how the economics of scaling in to a position work. Suppose you but a stock at $10 with a stop loss point of $9, giving you a risk of $1 a share. If you have a $1000 risk tolerance, you buy 1000 shares.
Soon after you enter the stock rallies to $11 and then trades sideways, building a base at $10.50. The stock breaks through $11 to $11.50, giving a new entry signal. Since support is now at $10.50, if you raise your stop on your first position to $10.50, you have locked in a profit of $500 (assuming the stock does not gap through your stop loss point and you are able to get out at $10.50).
Now, if you want to add to the position, you have a $500 profit to work with to mitigate your risk. If you buy another 1000 shares at $11.50 with a stop at $10.50, you have a second trade that has $1000 of risk. However, you have the $500 profit from the first trade to work with, so you risk is now only $500. Since you have doubled your position size, you have much more upside potential if the trade works.
You can continue to do this as the trade continues to work, building a larger and larger position. By doing so, you are using the money made on the early trades in the sequence to lower the risk of building a larger position.
Suppose you scale in to the position at $11.50, $12.50 and then again at $13.50. You now have 4000 shares without ever taking on any more risk. If you get a sell signal at $15, your total profit is as follows:
Original entry at $10, exit at $15 for $5000.
Second entry at $11.50, exit at $15 for $3500
Third entry at $12.50, exit at $15 for $2500
Fourth entry at $13.50, exit at $15 for $1500
Since the risk of the trade never exceeded $1000, the reward for risk ratio is 12.5 to 1. If we had only taken the original trade, the reward for risk would only be 5.
The downside is that we potentially forego a profit if the trend on the trade does not last long. If we scale in a few times and then get a rapid drop that moves against us, we may end up taking a small loss or breaking even when we could have had a small profit had we not scaled in.
What is important to remember is that traders make most of their money on a small number of their trades. To make the big profits, you have to trade for the big wins and grind through the small losses or break even trades.
Consider a trader who does not scale in versus one that does. Suppose the non scaling trader makes 10 trades with 3 out of 10 giving a loss of -1 reward for risk. 5 trades make a profit of +1 reward for risk, one trade makes a 2 and one makes a 7 reward for risk. Total profit over the 10 trades is -3 + 5 + 2 + 7 = 11. Pretty good, but contrast that with the trader who scales on the same trades.
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The scaling trader may have 4 trades that lose -1, 4 trades that make +1, 1 trade that makes 3 and one trade that makes 15. Total reward for risk over the same 10 trades is 18. The stock picking skill is no better, but scaling had a dramatic effect on total profitability even though the success rate (the percentage of trades that were profitable) went down.
This past week, I have been discussing and encouraging scaling in the daily edition of my newsletter. Here is a comment that I received from one of my readers who has been trading the inverse ETF on the S&P 500 index, the SDS:
“All right, despite the last few weeks being a tough environment to learn to trade in, I get what you mean about only needing a few good trades to make money, even in lousy markets. In the last few days my confidence got a huge boost, especially today. These major turning points are lucrative.
Today alone I extracted $7200 from SDS, an additional couple thousand in previous days. And I never risked more than a few hundred. Jumping in at the end of the day yesterday was of course beneficial, but I scaled in as the day went on today, more than doubling my position. I chose to sell out at the end of the day, even though SDS is likely a long term position trade. I expect a correction in SDS Monday and if not, I only missed some profits. I’ll find another entry point. Couldn’t leave the profits from today on the table.”
He was right on the trade, but scaling in grew the total profit dramatically.
I have been a buyer of the SDS for the past few days as I think the market is going to drop from here. This ETF goes up twice as fast as the market goes down. Given the action on Friday, I think this trend is likely to continue. It is a bit late to get in to the trade here but I think the reward for risk is still sufficient to justify taking the trade. Check the chart below to see how this ETF fell down to its upward trend line and bounced, making a green candle on Friday as the market reverses direction. It should now rally for a few days, meaning the overall market should drop for a few days. These are the kind of swing trade set ups that I am focusing on in the daily edition of the newsletter right now because the overall market is outweighing the movement in individual stocks.
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Tyler Bollhorn started trading the stock market with $3,000 in capital, some borrowed from his credit card, when he was just 19 years old. As he worked through the Business program at the University of Calgary, he constantly followed the market and traded stocks. Upon graduation, he could not shake his addiction to the market, and so he continued to trade and study the market by day, while working as a DJ at night. From his 600 square foot basement suite that he shared with his brother, Mr. Bollhorn pursued his dream of making his living buying and selling stocks.
Slowly, he began to learn how the market works, and more importantly, how to consistently make money from it. He realized that the stock market is not fair, and that a small group of people make most of the money while the general public suffers. Eventually, he found some of the key ingredients to success, and turned $30,000 in to half a million dollars in only 3 months. His career as a stock trader had finally flourished.
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This is not an investment advisory, and should not be used to make investment decisions. Information in Stockscores Perspectives is often opinionated and should be considered for information purposes only. No stock exchange anywhere has approved or disapproved of the information contained herein. There is no express or implied solicitation to buy or sell securities. The writers and editors of Perspectives may have positions in the stocks discussed above and may trade in the stocks mentioned. Don’t consider buying or selling any stock without conducting your own due diligence.