"Scaling out" is inferior behavior

[HolyGrail]

I just want to add one thing about myself. I am a swing trader and a position trader. As a swing trader I may allow that particular swing trade to turn into a position trade but I will scale out doing so I will eliminate most or all of my risk.

I also scale out on negative swing trades. If I buy a stock at 20.00 with an inital stop of 18.00 I will scale out half of my position at 19.00. Some people might consider than "non-optimal" but it has worked for me.

 

[AAAintheBeltway]

Quote from GTS:

Wow, I agree with B1S2 and can't believe that others don't see the obvious truth in what he is saying.

It may feel good to scale out after making 3 pts and hold the rest for the full 6 pts but the bottom line is that one or the other is the correct place to sell everything.

Psychologically it is comforting to take some money off the table and increase your w/l rate but financially it is a sub-optimal thing to do.

I don't see how this is up for debate - all it would take is a mechanical system, run it with three different parameters sets:

First sell everything at 3 pt profit target
Second sell everything at 6 pt profit target
Third sell half at 3 and half at 6pt

There is no chance that the third scenario is going to outperform both of the other two. Either selling all at 3 or selling all at 6 is going to be superior, doing half and half (scale out) just waters down the optimum strategy with the sub-optimal strategy.

I guess if you don't know what your optimal exit point (profit target) is then scaling out could make sense but it seems like it would be worth your time to go through your trade history and figure when the optimal exit point is (would have been) and then just use that going forward.

Maybe I'm missing something but it seems pretty black and white to me.

(Edit: This is not to say that I never scale out, just that I realize what I am doing is not optimal - being human sucks like that)

While I tend to agree with you conceptually, I think there is a statistical flaw in the argument. You must assume that the historically optimal exit point remains optimal into the future. Look at the ES. For a long time in the '90's (ok, there was no ES then but the S&P futures is the same thing), the optimal play was to get long and hold through thick and thin. We were in a bull market. That changed and holding overnight after a trend day became a recipe for disaster.

Scaling out is by definition sub-optimal, but it is seldom the worst possible strategy. The key however is that if you do scale out, you need to have a valid approach for doing so. Selling a portion just because it shows a profit is definitely not it.

 

[AAAintheBeltway]

Quote from austinp:

While I watch the charts wedge into typical index-option expiry death coils, let me add a couple of thoughts:

#1: In writing countless mechanical systems, every example with no exceptions showed diminished overall profit AND smaller profit per trade size using a scaled-out approach.

Why? Very simple. Some trades over a large sample size will go z-number of points in favor of typical entry signals. w-number of trades will immediately go against the entry, and y-number of trades will slop around in sideways fashion.

When building a system - method - approach, we must have some idea where to harvest profits from. That is critical for several reasons... in picking initial stop-loss / risk parameters, and managing winners.

In order to maximize overall returns AND per trade profit size, those z-trades need be captured in highest efficiency possible. There is no good way to manage the y and w type trades... they never offer much if any real profit potential.

The z-type trades are where an account balance grows. That is the edge, that is the bankroll. Any tactics used to exit z-trades early will directly diminish said bankroll.

In order to know our trade approach is sound, we must first prove that some number of trades will go far enough in favor to offset all else. If we know for a fact that exists in our approach, we must therefore treat <b>each and every trade</b> as if it will be a z-type result for maximum overall profit and per-trade potential.

*

Here's the human pitfall which overrides system trading: emotion places <u>more emphasis on each and every single trade</u> than emphasis on overall cumulative data from large sample size.

Said another way, we trust that some trades will progress far enough past entry to make us overall profitable, but we fixate on the results of the current trade more than overall blend of results.

You see where I'm going. Traders do go broke taking profits... that happens all the time. It happens because they take too small profits from z-type trades which is the essence of their edge. Little can be done to manage the rest, so small profits are erased = negated by small losses.

**

Whether scaling out is wrong for everyone or not is debatable. What is a mathematical fact on the topic? Write any mechanical system and add scaled out partial profit rules instead of all-out rules at optimum AVERAGE profit size. See what the results are in overall profit and per-trade profit size for each scenario. I know the answer already... but you'll believe your own math a whole lot more than you'll believe mine :>)

Hope this helps and/or entertains

Great points, and my own backtesting confirms them.

Let me pose a real world complexity however. In my backtesting, I would generally have an exit rule tied to market action, eg cross a MA or put in a reversal bar. In real time trading however, we have the benefit or curse of seeing the trade unfold. At times we see market action unfolding that gives us the impression the probability of a "z" type trade has significantly decreased. We are faced with risking paper profits against the perceived lowered probability of a z trade reward. What are we to do? Trust blindly or use discretion?

 

[Buy1Sell2]

Quote from HolyGrail:

I would do none of the above. I would hold a portion for LONGER than the 6 points depending on the stock and the overall condition of the market, and if it still met my holding criteria. Playing with the houses money is not a crutch. It catches extremely long runs.

The entire position should be held for longer.

 

[Buy1Sell2]

Quote from AAAintheBeltway:

.

Scaling out is by definition sub-optimal, but it is seldom the worst possible strategy.

This is correct. I only said it was inferior, I did not say it was the worst.

 

[Buy1Sell2]

Quote from austinp:


Traders who decide = prefer to scale out of positions usually do so for emotional reasons. In reality, that is often a very important part of success or failure in the continued evolution as a trader.

Precisely

 

[Buy1Sell2]

Quote from GTS:


Psychologically it is comforting to take some money off the table and increase your w/l rate but financially it is a sub-optimal thing to do.

This also is a correct statement. What you have with scaling out, is traders playing to not lose, instead of playing to win.

 

[illiquid]

Bottom line is that it's a personal question that has no blanket answer.

The primary rationale I have for entering full size but scaling out is that my entries and exits are almost always non-symmetrical: meaning, I have a higher standard for entering a trade than I do for exiting a winner. Sure, there are a few cases here and there where a clear signal to exit is given, so clear in fact that it merits a reversal of the position. But those rarely occur; if they happened all the time, I would be either long or short round the clock. In most cases however, the exit just isn't as clean as the entry, nor should it be in the way that I see my trades. That's just my personal justification, and it works fine from here.

In fact, if you see the markets as "discounting mechanisms" (and I'm sure there are many of you that don't need to for your trading methods), then logic dictates that you scale out of a profitable trade. Why? Price moving in your favor on your profitable entry means that others are finally catching up to your point of view. The more buying/selling impetus that occurs, the further price moves to reflect the momentum. If this shift was the reason for your entry in the first place, you have less and less reason for holding a full position as the shift gets priced in.

So in response to the first post of the thread: you are right, I do scale out of a position because I am uncomfortable with the size I am holding - at the time that I start to let some go. It has little to do with how much I held or was comfortable with when I first opened the position. As price moves, so does risk/reward, and scaling seems to be the only logical response for dealing with price as a function of discounting.

 

[HolyGrail]

We are leaving out the most important factor, the risk vs reward.

If a six dollar move is a 6r then there is nothing wrong with taking 3r at three dollars.

 

[illiquid]

Quote from Buy1Sell2:

This also is a correct statement. What you have with scaling out, is traders playing to not lose, instead of playing to win.

These are all relative statements that have no significance without case-by-case detail.

But it's funny you wrote the above, because my biggest problem for the longest time was holding my profitable positions too long -- scaling out became my remedy for that.