Everyone trading should have a system of three key elements; an entry strategy, an exit strategy and a position sizing/risk management strategy.
In this article we will look at one of these elements, the Exit Strategy Your Exit Strategy should do three things - minimize losses, maximize profits while limiting the amount of profit you give back.
As an example, say you open a position with 300 shares with an average price of $10 each.
Let's also assume that your Exit Strategy is to exit this position either when the price reaches $15 or you hit a 10% trailing stop.
Scaling Out is a type of Exit Strategy whereby you plan to exit your position in several planned increments as opposed to closing the entire position at once.
Using the above example again but this time Scaling Out, you might plan to sell 100 shares when you reach $13, another 100 when you reach $14, then you would sell the last 100 when you made your profit target of $15, or keep the position even longer to let the price run.
This Scale Out method is commonly thought to reduce losses and increase profits, following the idea of banking your profits.
However it has an unfortunate characteristic that has nasty effects on your profits - Reverse Position Sizing.
Position Sizing is a key area of any trading system.
Your position size determines the amount of exposure to loss you have on any position you hold by limiting the number of shares held when you are the most vulnerable.
If the trade goes against you and you hit your stop or exit criteria, you take your loss.
However if your trade goes the way you think it will you take the profit on the entirety of your position.
However if you adopt Scaling Out, you will still have the same maximum loss, but you have the fewest shares in your position when your point gains are the highest.
Instead of banking your profits it simply means that overall you lock in the same losses, but reduce your profits compared to exiting in one hit.
In fact the reverse concept of Scaling In is a better trading model to follow.
This ensures that you put more money into trades that are working and less into those that do not.
So let us use the above example, but instead of opening our trade with the full 300, let's assume we open with only 100, with our same 10% trailing stop.
Now we can only lose 10% of our smaller position size, so our loss at this point is 1/3 that or our original plan.
As the price moves up and our trailing stop hit's our entry price, in this case $10, we add another 100 to our position.
If it moves a further 10% higher, then we add to our position again.
Our risk is still limited to the smaller amount but we now have the same position size as before.
Since this allows us to reduce the amount at risk, we can concentrate our funds into the trades that are making money, while keeping the amount at risk at the same level.
This fulfils the goals of an Exit Criteria far better than Scaling Out.
Scaling Out is very popular among traders, as it intuitively sounds sensible.
However this Exit Strategy is actually quite destructive.
I must admit that this concept is very counter-intuitive and it took me a long time to see the issues with it.
If you do use Scaling Out, do not kick yourself too hard.
The fact that you have put an Exit Strategy into place means you are ahead of the vast majority of your peers, unbelievably less than 20% of traders actually have an Exit Strategy they adhere to! Trade well.
In this article we will look at one of these elements, the Exit Strategy Your Exit Strategy should do three things - minimize losses, maximize profits while limiting the amount of profit you give back.
As an example, say you open a position with 300 shares with an average price of $10 each.
Let's also assume that your Exit Strategy is to exit this position either when the price reaches $15 or you hit a 10% trailing stop.
Scaling Out is a type of Exit Strategy whereby you plan to exit your position in several planned increments as opposed to closing the entire position at once.
Using the above example again but this time Scaling Out, you might plan to sell 100 shares when you reach $13, another 100 when you reach $14, then you would sell the last 100 when you made your profit target of $15, or keep the position even longer to let the price run.
This Scale Out method is commonly thought to reduce losses and increase profits, following the idea of banking your profits.
However it has an unfortunate characteristic that has nasty effects on your profits - Reverse Position Sizing.
Position Sizing is a key area of any trading system.
Your position size determines the amount of exposure to loss you have on any position you hold by limiting the number of shares held when you are the most vulnerable.
If the trade goes against you and you hit your stop or exit criteria, you take your loss.
However if your trade goes the way you think it will you take the profit on the entirety of your position.
However if you adopt Scaling Out, you will still have the same maximum loss, but you have the fewest shares in your position when your point gains are the highest.
Instead of banking your profits it simply means that overall you lock in the same losses, but reduce your profits compared to exiting in one hit.
In fact the reverse concept of Scaling In is a better trading model to follow.
This ensures that you put more money into trades that are working and less into those that do not.
So let us use the above example, but instead of opening our trade with the full 300, let's assume we open with only 100, with our same 10% trailing stop.
Now we can only lose 10% of our smaller position size, so our loss at this point is 1/3 that or our original plan.
As the price moves up and our trailing stop hit's our entry price, in this case $10, we add another 100 to our position.
If it moves a further 10% higher, then we add to our position again.
Our risk is still limited to the smaller amount but we now have the same position size as before.
Since this allows us to reduce the amount at risk, we can concentrate our funds into the trades that are making money, while keeping the amount at risk at the same level.
This fulfils the goals of an Exit Criteria far better than Scaling Out.
Scaling Out is very popular among traders, as it intuitively sounds sensible.
However this Exit Strategy is actually quite destructive.
I must admit that this concept is very counter-intuitive and it took me a long time to see the issues with it.
If you do use Scaling Out, do not kick yourself too hard.
The fact that you have put an Exit Strategy into place means you are ahead of the vast majority of your peers, unbelievably less than 20% of traders actually have an Exit Strategy they adhere to! Trade well.