Wednesday, February 4, 2009

The Conundrum of Scaling Out

Some do, some don't. Almost every trader has an opinion on the subject and each are as adamant as the next behind the logic of their decisions to either scale out or not. So lets dive into it just a bit. (I'm bored this evening in case you couldn't tell.) I don't intend to sway you one way or another but explain what I feel are the pluses and minuses of each argument and finally present data from my own trades showing the difference in profits between scaling half out at a par level and holding an all-in-all-out strategy. I don't want to make a novel out of this as its been hashed about by traders way smarter than me before so we'll keep it short and concise.

Reasons to scale out:
  • Probability of hitting smaller profit targets are larger.
  • Emotional feeling of success "locking in a profit" allows one to hold (in theory) for larger gains.
  • You take more profit more of the time.

Reasons to manage all-in-all-out:
  • Keeps your risk:reward in check (we'll get into this in a bit)
  • You don't cut your winners short.
  • You don't allow yourself to "feel like a winner" until you indeed, are a winner.

So my biggest problem i've had justifying scaling out relates to the risk and reward that results from scaling. Here's an excerpt from AustinP (my mentor) as explained here in his write up on this very subject (which I recommend everyone reads!):

50% Win Ratio Using Two Contracts
Two ES contracts: 50% win ratio
+4pt profit target = both contracts: $400
-2pt initial stop = both contracts: ($200)
Average winning trade: $400
Average losing trade: ($200)
Average trade: $200
Ten average trades: +$2,000

Two ES contracts: 50% win ratio
+2pt profit target = one contract: $100
+4pt profit target = one contract: $200
-2pt initial stop = both contracts: ($200)
Average winning trade: $300
Average losing trade: ($200)
Average trade: $100
Ten average trades: +$1,000

His full discussion dives into the win rates of each, scaling out in even more progression but the end results always seem to be the same... scaling out doesn't make as much money.

So I decided to do the same analysis on my live trades i've taken. First I just ran outcomes on this week alone, a week that has been rife with par trades. And would you know it - it was more profitable to scale out in that scenario. Wow. But then I expanded the data to include the past two weeks as well and the end result flipped on me. Scaling out netted no money whatsoever and staying in trades all-in-all-out netted 375.00. That's quite a difference.

The folks at Trade The Markets take the insanity to the next level. I think JC scales out at +4 ticks, +8 ticks, and then goes for a runner all with around a 4 point initial stop... That's all well and good but that means that he has 600.00 worth of risk on each trade and cuts out 66% of his position when he realizes 150.00 worth of gains! Really? So to even get a 1:1 scenario on the trade he has to have a runner go 9 points in favor!!! And what happens if they do hit a 80% win rate and get 4 trades that get their first two targets for a net profit of 600.00 (4 X 150.00 = 600.00) and then the fifth trade comes along and stops them out for -600.00 they are back to square one. So their profitability would be directly correlated to the amount of runners they got (which I don't think is THAT high). But even so, why not JUST HOLD ALL THE CONTRACTS FOR THE RUNNER? I just think this kind of stuff can't actually be justifiable in the long run. Thankfully the TTM web site netted good ole JC over 1 million bucks last year alone.

I think a lot of new traders scale out because it allows them to feel successful, safe, and profitable more of the time rather than holding for what their trade was really supposed to do and getting paid for it. And then there is the possibility that i'm full of shit and I don't have a clue what i'm talking about. All I know is if I was learning to trade and someone told me to manage like that I would love it because I would be able to tell myself that I was reducing risk, locking in profits, and yada yada all while I can't seem to be able to turn a profit.

Every scenario i've seen with my own method of trading can't justify scaling out as a more effective management scenario. There are certainly counter arguments here (many of which i'll hear about in my comments) and I welcome them, but on my data, my systems, and my real trades there is just no cold hard benefit to my bottom line.

So... this is just my opinion. Its pretty obvious where my thought lies, but at least when it comes to my setups and my methodology I have the data to back up my opinions. Different methods, systems or styles may very well favor scaling out but i've yet to see one that can really prove it to me with numbers.

Thoughts? Comments? Want to call me a bad name? Lets get some dialogue going!


E-Mini Player said...

I'm assuming you were using 2-contracts in your scale-out scenario. Did you run the #s with 3 contracts (scaling out 1/3)?

I'm definitely a believer in having a positive R:R (I think talking to you every day rubbed off on me), but at the same time, I like the idea of scaling out. But the way that I would do it is by exiting 1/3 of the position at my initial price target, which if I was risking 2 pts, would need to be 4 pts. Once I've hit my initial 4 pt target. I would lock in profit on 1/3 and move my stop to break-even or 1R on the remaining 2/3. Now lets say the position goes +6 pts in my favor, again I would scale out and lock in profits on 1/3, and here I would either move my stop up another 1-2 points, or maybe just leave the stop at 1R (+2 pts) and let the remaining position run with a trailing stop.

That's probably what I would if I was trading 3 contracts or multiples of 3.

Btw, log onto Yahoo messenger if you're so damn bored LOL :D

E-Mini Player said...

I think you should also start thinking about the conundrum that is, the title of you Blog...does it change to By Age 24 in May? :P

Matt said...

This blog was once called by age 22... lol...

I'm already a year behind!!!

Ziad said...

Statistically speaking, i've read a couple of books about long-time pros who have done years and years of backtesting on virtually every kind of trading strategy, and the net overall profit of all-in-all-out is pretty much always more than scaling out. It didn't matter what was tested - all out was superior to scaling out. So your own analysis is correctly reflecting this over a large sample size. However, it WAS found that while scaling out decreases your overall bottom line, it also decreases your P&L volatility. i.e. you make less money, but you generally get better consistency.

So if a trader cares more about having a low volatility equity curve for any given period than having a more profitable but more volatile one, then they can go with scaling out. It all depends on what you value more.

But even then it's not so simple to assume that you'll actually end up with a lower overall bottom line by going with scaling out if you are a pure discretionary trader. With trading, the issue is never just about stats. There are intangible forces that can end up having huge effects which can't be measured. For instance, say scaling out makes a trader more at ease because his equity curve is less volatile, and as such he is more aggressive in taking trades and managing them (again assuming he doesn't have mechanical rules). Well then this could end up giving him a larger bottom line than going all-out DESPITE the statistics. In this case, the intangible benefit of being more aggressive (assuming it is prudent aggressiveness) due to feeling more at ease with the lower volatility equity curve could more than outweigh the statistical disadvantages of scaling out.

In the end I'm not proposing that one should scale out, but rather highlighting how pure statistical analysis can't really show you what the best outcome would be unless you are purely mechanical and 100% disciplined to follow the exact system no matter what.

I'm purely discretionary, but I still choose the all-out method, as I prefer overall profitability over the emotional comfort I can get from having a smooth P&L. And to still get the benefit of added aggressiveness despite not having the sense of comfort from a smooth equity curve, I condition my mind to remain aggressive despite stretches of losses. Obviously this is easier said than done. But in fact that's the very reason why all-out statistically gives more profits. It's BECAUSE it's more emotionally difficult to do that it naturally rewards you more. Simple logic there.