When Scaling Is Hazardous to Your Trading

07/03/2013 6:00 am EST

Focus: FUTURES

Most seasoned traders advise scaling into trades, but scale trading in futures could wipe out your account, writes Kevin Davey of KJ Trading Systems.

I have been trading futures for about 18 years, and many of the early years were consumed with searching for the “perfect” trading system. One of the approaches I found that seemed to make sense was scale trading. It is an interesting concept that “wins” most of the time, but is really only appropriate for those with very deep pockets who can stomach occasional enormous drawdowns.

In a nutshell, scale trading buys futures in a physical commodity as it approaches a “bottom,” and sells at small profits. So, for example, you might decide that wheat is near a bottom, and buy each time the price drops down by 10 cents, which is $500 nominal value for one Chicago wheat contract. On the sell side, you might decide to sell each wheat contract 5 cents above what you paid for it, for a $250 gross profit.

So, since you always wait for prices to recover, nearly every trade is eventually profitable, and the winning percentage is very high. This high winning percentage, typically over 90%, is what lures many unsuspecting traders in.

With scale trading, you are betting that the laws of supply and demand will eventually cause wheat, or any other physical commodity, to increase in price. As the price increases, you'll bank a small profit on each contract you purchase and later sell.

As you might have guessed, the big problem with this “adding to losers” technique is that you do not know where the exact bottom is, or when prices will recover. In the worst case, you'd have to keep adding contracts, and hold them for possibly years, rolling them over every few months and incurring costs along the way. The laws of supply and demand tend to take time to work, usually months to years. Just because wheat is low today does not mean it will absolutely be higher next month, next year, or even five years from now.

Financially, scale trading as a strategy is doomed, if you misjudge the situation and start buying contracts a long way from the bottom. As the price descends, you could find yourself easily holding 10 or more contracts, which is a big problem unless you have deep pockets, and can afford to wait.

Psychologically, scale trading is a killer because you may find yourself fighting a downward trend, and adding contracts as the situation gets worse. It is basically refusing to admit you are wrong, and backing up that refusal by digging a deeper hole.

I can tell you from personal experience that scale trading works when you anticipate the correct bottom, and start buying close to that bottom. But, I can also tell you that if you estimate the bottom incorrectly, you will run out of money, patience, or both, before you turn a profit. That's what happened to me—after some initial success, I suddenly lost my ability to pick bottoms, and quickly wiped out my account.

So, be careful if anyone ever suggests scale trading. Like many other approaches, it can work if you execute it flawlessly, but if you don't, you could find yourself in a deep financial and psychological hole.

By Kevin Davey of KJ Trading Systems

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