A trader\'s money management system

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c08 JWBK182-McDowell April 25, 2008 16:4 Printer: Yet to come

70 A TRADER’S MONEY MANAGEMENT SYSTEM

The psychology of scaling out is to reduce stress by locking in profit,

which should help you stay in trends longer with your remaining positions.

SCALING IN TO A POSITION AND

INCREASING TRADE SIZE

Since this is a book on money management and risk control, it is appro-

priate to discuss how to control risk on a popular strategy of adding onto

trends to increase your trade size with the goal of increasing profits. This

technique is calledscaling inoradding onto a trade in progress and is

usually used intrend trading.

The basics are to increase your trade size on an already profitable trade

while maintaining strict risk control throughout the trade. The reason for

scaling in to a trend is to gain more profit through a larger trade size. It is

important to distinguish scaling in from another technique known asdou-

bling down,which is a form of adding to your trade size. Unfortunately,

doubling down also increases your trade risk.

With doubling down, you add to your trade size when the trade goes

against you and your open trade is currently at a loss. By adding to your

position at a time when your position is losing, you are increasing your

trade size and lowering your cost basis. However, you are also increasing

your trade risk since the new added-on position will assume risk in addi-

tion to the risk of your initial open trade. Thus, you have an increase in the

overall risk of your trade. For this reason, doubling down can be a loser’s

game, since your risk increases beyond the risk-of-ruin percentage guide-

lines used to carefully calculate your trade size, which determines your

trade risk on the initial position.

A better way to add on to your current position is to add ononlywhen

your stop loss on your initial trade size moves to a price level where there

is no longer any trade risk. This means that if you are stopped out, your

initial trade is either a break-even trade or a profitable one. Moving your

stop loss in this fashion is called atrailing stop.

Thus, when you are adding on or scaling in to a trade using this tech-

nique, you are not incurring additional trade risk since your new trailing

stop loss nullifies the risk assumed from the initial position taken. When

scaling in, you scale in with a trade size that is, again, carefully calculated

so that your add-on position has a trade size that is within the risk-of-ruin

guidelines. After scaling in, your new overall trade risk is the risk of the

add on only.

A final word of caution needs to be mentioned in regards to scaling

in or adding on to any position. Although we can controltrade riskby