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As part of a money management set of rules, scaling is a wonderful strategy. In trading, to scale means to use different levels when entering a trade, with the idea of averaging a better entry.
It is only normal to think this way. After all, trading is a risky business and managing the risk involved is more important, or at least equally important than the analysis that stands behind a trade.
A money management plan involves the number of trades to be open in a portfolio at any one moment of time. That is, the maximum number of trades and the maximum volume in such a way that the account is not over traded and drawdowns will not result in a margin call.
But every entry can be divided in multiple trades of a lower volume. This is when scaling becomes efficient as a trading tool.
It all starts with the analysis involved. No matter if the trade is the result of the technical or fundamental analysis or both, scaling is useful when entering the trade.
No one should put all the eggs in the same basket. The same in trading: no one should risk taking a trade at the same level.
Splitting the risk equals splitting the position in multiple small entries. Volatility is tough to handle, especially in markets like Forex.
The following steps are part of the scaling process. However, depending on the money management system, other things can be part of it as well.
The first step is to start from the reason why entering a trade. This should be either fundamental or technical or both.
The chart above shows the EURUSD on the daily time frame and the analysis is based on the Elliott Waves theory. It shows a contracting triangle that most likely ended.
The outcome of this triangle is a bullish one, and the logical step would be to go long or to buy the pair. However, there is a risky approach and a conservative one.
A risky approach would be to simply go long and wait for the target, a complete retracement of the whole move. If the trade is correct, a nice profit is about to be made.
However, this is a risky trade. The e-wave of a contracting triangle can take various shapes and at this point in time, it is simply impossible to know if the e-wave is completed or not.
If it is not completed, there is no guarantee that the market will not make another move lower. Even if it is not making another move lower, it may consolidate for some more.
This is still a cost, as the time frame is a big one. Daily swaps are generally negative, and a few weeks or more of consolidation will result in the position being a costly one.
Moreover, the margin is blocked in a trade that is not moving when it could be used for other trades. To avoid all these, scaling can be used.
Let’s assume the money management system at this point in time, for this trading account, calls for a 0.5 volume of every trade. Using the above example, the risky approach would mean to go long at the market, 0.5 lots, and wait for the target.
A conservative one implies scaling. The idea is to divide the volume into multiple entries. While the reward or the potential profit is not the same, the risk is smaller and managed easily.
To scale means to entry at different levels, when the market is confirming the pattern or not. This would result either in better entries or in entering a trade after confirmation.
The 0.5 volume can be split into two, or three, or five, or even more entries. For our example, we’ll split it in five entries, 0.1 each.
In the EURUSD example, a confirmation of the whole pattern would be when the b-d trend line is broken. That is a good entry for one of the 0.1 trades.
Because that is a higher level than the current one, a pending buy stop order should be placed, for 0.1 lots. Again, a break there implies the market will completely retrace the previous downside move.
Another 0.1 position could be traded at the market, and then wait and see how the market is moving. The idea behind scaling is to average the best possible position for your trade.
Therefore, if the market is going against the trade, there are three more entries to be made. This will result in a better average for the 0.4 lots before the triangle is broken.
Conservative traders will always wait for the b-d trend line to be broken before entering such a trade. However, the opportunity cost is high because of the time frame involved. There are hundreds of pips between the current price and the moment the b-d trend line is broken.
Assuming all 0.1 trades are active, the result will be a 0.5 lots position on the long side, averaging a better level than either entering at the market or waiting for the b-d trend line to be broken and taking a 0.5 lots trade. This is called scaling in a position and the example used in this article is quite an easy one.
Scaling as a strategy is widely used by money managers and fund managers, but the principle is the same as described in this article. The only difference is that the size of the trades is different and the implications are different as well.
Scalability is defined as the ability to have the same consistent returns by the time the trading account is growing. Scaling and scalability are two different things, but one is helping the other. To achieve same compounded results with bigger funds is something that can be done only by using different scaling techniques. Again, managing risk is more important than the actual analysis that is the base for taking a trade, and risk managers are successful managers.
