In
part I, I mentioned how scaling into trades ends up increasing the complexity of your system while reducing the edge and thus your profitability. Now, on to scaling out of trades.
Scaling out of trades is pure magic. Yes, magic. The more I think about scaling out of trades...the more I realize how powerful this technique is to your system. Think of it this way. Scaling out of your trades gives you the chance to create trading systems that are 100% profitable. How in the world can you beat that? :)
Let's get to work. Here's the 1st example we'll work with:
Full Deck MethodStarting Equity: $35,000.00
Symbol: XYZ
Shares: 1,000
Entry Price: $35.00
Exit Price: $52.50
Gain/Loss%: 50.00%
Gain/Loss$: $17,500.00
Results:New Adjusted Equity: $52,500.00
Net Profit%: 50.00%
Net Profit$: $17,500.00
Win Ratio: 100.00%
Number of Trades: 1
Not too shabby for an old dog like yourself, eh? Keeping your deck fully loaded throughout the trade thus capitalizing on the big 50% move.
Now, what happens when you attempt to scale out instead? Let's keep it simple, we'll break the scales into quarters and scale out at the 6%, 18%, 32% profit mark, and then let the remaining quarter ride. So, here's what the trade looks like:
Scale Out MethodStarting Equity: $35,000.00
Symbol: XYZ
Shares: 250
Entry Price: $35.00
Exit Price: $37.10
Gain/Loss%: 6.00%
Gain/Loss$: $525.00
Symbol: XYZ
Shares: 250
Entry Price: $35.00
Exit Price: $41.30
Gain/Loss%: 18.00%
Gain/Loss$: $1,575.00
Symbol: XYZ
Shares: 250
Entry Price: $35.00
Exit Price: $46.20
Gain/Loss%: 32.00%
Gain/Loss$: $2,800.00
Symbol: XYZ
Shares: 250
Entry Price: $35.00
Exit Price: $52.50
Gain/Loss%: 50.00%
Gain/Loss$: $4,375.00
Results:New Adjusted Equity: $44,275.00
Net Profit%: 26.50%
Net Profit$: $9,275.00
Win Ratio: 100.00%
Number of Trades: 4
Wow! That's rough. The Scaling Out Method cut our profits almost in half when compared to the Full Deck Method. What kind of magic dragon you've been puffing Taylor? But, there's another layer hidden behind these numbers. This hidden layer is a roller coaster filled with ups, downs, and a whole lotta nothins that earning 50% on your investment requires.
What if I told you that in order to achieve that 50% return you had to witness a run-up to $46.20 (32% profit) then a fall back down to $37.10 (6% profit)? That's a 20% drawdown in the trade or $9,100.00 in paper profits just wiped away.
Now, you're probably thinking...no way! I have trail stops buddy! I'd never trail my stops 20% or more from the high/close/whatever. If that's true then you'd never achieve that 50% profit for this particular trade example. And since trail stops are a whole nutha beast let's move on.
So, back to the example. If you scaled just like we discussed before...instead of $9,100.00 paper profits vanishing along with your hopes for the trade...only $2,275.00 is lost (4th scale still open) while $4900 (3 scales sold) in actual profits are locked-in. This Scaling Out Method works to lock in your profits but more importantly reduce the drawdown in the trade.
Let's keep testing. What if in the example above we had another trade after the XYZ stock. This new trade was in the ZZZ stock and believe it or not lighting does strike twice in the same portfolio because this trade worked just like the XYZ stock. Hit every mark...but instead of climbing back from that 20% drawdown from the peak of 32% profit...it never came back? And instead you were forced to close out with the paltry 6% profit. What kind of details would that give us...
Full Deck MethodStarting Equity: $35,000.00
Symbol: XYZ
Shares: 1,000
Entry Price: $35.00
Exit Price: $52.50
Gain/Loss%: 50.00%
Gain/Loss$: $17,500.00
New Adjusted Equity: $52,500.00
Symbol: ZZZ
Shares: 1,000
Entry Price: $35.00
Exit Price: $37.10
Gain/Loss%: 6.00%
Gain/Loss$: $2,100.00
Results:New Adjusted Equity: $54,600.00
Net Profit%: 56.00%
Net Profit$: $19,600.00
Win Ratio: 100.00%
Number of Trades: 2
Max Equity Drawdown:
-19.69%Scale Out MethodStarting Equity: $35,000.00
Symbol: XYZ
Shares: 250
Entry Price: $35.00
Exit Price: $37.10
Gain/Loss%: 6.00%
Gain/Loss$: $525.00
Symbol: XYZ
Shares: 250
Entry Price: $35.00
Exit Price: $41.30
Gain/Loss%: 18.00%
Gain/Loss$: $1,575.00
Symbol: XYZ
Shares: 250
Entry Price: $35.00
Exit Price: $46.20
Gain/Loss%: 32.00%
Gain/Loss$: $2,800.00
Symbol: XYZ
Shares: 250
Entry Price: $35.00
Exit Price: $52.50
Gain/Loss%: 50.00%
Gain/Loss$: $4,375.00
New Adjusted Equity: $44,275.00
Symbol: ZZZ
Shares: 250
Entry Price: $35.00
Exit Price: $37.10
Gain/Loss%: 6.00%
Gain/Loss$: $525.00
Symbol: ZZZ
Shares: 250
Entry Price: $35.00
Exit Price: $41.30
Gain/Loss%: 18.00%
Gain/Loss$: $1,575.00
Symbol: ZZZ
Shares: 250
Entry Price: $35.00
Exit Price: $46.20
Gain/Loss%: 32.00%
Gain/Loss$: $2,800.00
Symbol: ZZZ
Shares: 250
Entry Price: $35.00
Exit Price: $37.10
Gain/Loss%: 6.00%
Gain/Loss$: $525.00
Results:New Adjusted Equity: $49,700.00
Net Profit%: 42.00%
Net Profit$: $14,700.00
Win Ratio: 100.00%
Number of Trades: 8
Max Equity Drawdown:
-5.33%Now where getting somewhere. The Full Deck had 2 winning trades, $19,600 profit, and a -19.69% system drawdown. Scaling Out had 8 wins, $14,700 profit, and -5.33% system drawdown. So, who's the winner?
Well, the Full Deck Method still earned almost 10% more in profits than the Scaling Out Method. But, with 300% more in system drawdown I think it's fair to say the Scaling Out Method provides the better return for the amount risked. Throw in just one more trade that is a loser to boot and the whole ball games changes. Currently, the win ratio on both systems are 100%. But, with a loser added to the mix the Full Deck Method would drop down to a 67% win ratio. While the Scaling Out method at a worst case scenario would still achieve an 89% win ratio. And could be better if just one of those scales were made before the trade turned into a loss.
What do you think? A way to lock in your profits, free up your money quicker, let some profits ride, reduce your system drawdown, and increase your win ratio to boot. Not too shabby, eh? But, what I like even better is again...where else do you get the chance to create new trading systems with guaranteed profits?
Now, please don't get picky on me. I'm not counting slippage and commission costs into the mix. Feel free to do that when analyzing your own trades. And the 6%, 18%, 32%, and let it ride scale is just an example. By all means, test out different combination of scales in your own trades. Should be enough to keep you busy for a good long while. :)
Rants:I've been a programmer for 10+ years now. This has involved working with many other programmers both old and new. Know what the most common fault I have witnessed over these 10 years? The failure to test ideas. The failure to test programs. We think it should work, so it must. Ha!
Just what do we have against testing? Why do we feel the need to pontificate on things that can easily be tested? It's a really strange phenomenon that even I'm guilty of from time to time. And I know better!
I think the key is this: Avoid trying to prove an idea with logic and speculation. Use logic and speculation to create ideas and use testing to prove whether those ideas are indeed valid. Maybe logic is not the correct term here. But, I hope you get my meaning.
Side Note:
If you've had a good day, week, month, or year...do you reward yourself for trading well? I haven't really done this before but I'm beginning to think this is a good idea. If all you do is roll the profits back into the business then where's the reward for all your efforts? Usually, my reward or gratification comes from the creation of new systems or learning of new tools/ideas/methods. And of course, writing this blog helps to communicate my thoughts to an audience that can understand and appreciate what I do. That's a reward in itself. But, maybe
Rod Tidwell is seeping into my brain and a little part of me is shouting...SHOW ME THE MONEY! Ha ha.
Anyway, upon this theme...I'm thinking about getting a
Kodak Digital Camera (EasyShare DX7440 4MP with 4x Optical Zoom for a little reward. I'm a photo-taking newbie so if anyone has any comments on this camera or any other good digital cameras in the $200 - $300 range, please let me know.
