Scaling is a risk management tool used by traders in many different markets. Rather than entering into or exiting a position all at once, traders using a scaling strategy will approach these positions gradually.
Risk management is one of the most important components of developing an effective trading strategy. Without taking the proper steps to minimize your exposure to risk, you will quickly find yourself losing large amounts of money at once. If you are able to reduce your exposure to risk while still protecting the possibility to earn strong returns, you will be much more likely to see the trading outcomes you are hoping for.
One of the keys to risk management is controlling your overall level of exposure. When it becomes possible—even if it is unlikely—to lose all your wealth at once, your position is highly exposed. When your wealth is protected, regardless of whether markets are bearish or bullish, then the risk of holding that position will naturally be much less.
In this article, we will discuss the most important things for you to know about developing an effective forex scaling strategy. Scaling is especially popular in the derivatives market, where investors have more flexibility and control over their positions. By taking the time to learn about this unique approach to trading, you can develop a much more effective trading strategy.
What is scaling?
Scaling is defined as “adding or removing units from your original open position” in response to changes in the market. Rather than opening and closing dramatic positions all at once, risk-averse investors will scale these positions to make them much more manageable. Think of scaling as the trading equivalent of dipping one foot in before you jump into the pool.
Suppose that a stock is currently trading for $100 and that a prospective investor has $1,000 they are hoping to invest. If the price is currently dropping (and is expected to continue to drop), the investor might purchase 3 shares at $100, 2 shares when the price drops to $98, 1 shares when the price drops to $96, and another 4 shares when the price drops to $94. This is an example of a scaling trading strategy.
In the end, the investor is holding 10 shares, each valued at $96 (meaning she has $960 worth of wealth). Though, on paper it would appear she has lost $40, she has actually only spent $968 getting to her position, meaning the loss only amounts to $8 thus far. If the price increases in value back up to $1,000, she will be able to exit with a $32 profit. Scaling is ideal for stable securities with predictable price channels. Using channel indicators, such as Bollinger Bands will make it much easier to identify these channels.
What is the difference between scaling out and scaling in?
There are two different forms of scaling: scaling in and scaling out. As these names might suggest, scaling in involves gradually entering into a new position. Usually—as can be seen in the example mentioned above—scaling in is characterized by purchasing more securities as the price drops towards the bottom of the channel.
Scaling out is the exact opposite of scaling in. Instead of purchasing shares as prices drop, scaling out involves selling shares as prices increase. Scaling out is a form of exiting a position. By selling shares gradually, rather than all at once, traders can lock in a portion of their gains while still being able to exploit price increases. On the largest possible “scale”, many company founders scale out by selling small portions of their stock every few years, usually in response to price increases.
What are the risks and benefits of scaling?
There are many benefits of developing a scaling strategy. Scaling is generally perceived as a risk management tool that minimizes your exposure to the risk of certain price changes. If prices were to begin dropping, for example, scaled out positions will have already generated at least some profit. As long as markets remain speculative—which they surely will—scaling is one of the safest to ease yourself into and out of a specific position.
As you will find with most trading strategies, anything that decreases your exposure to risk may consequently decrease your potential for strong returns. In the example mentioned earlier, watching the stocks rise from $96 to $100 yielded the trader a $32 profit. However, if they would have waited and gone all in at $96, their profit would have been $40. By gradually entering into a position, you may miss out on some potential gains. However, in the real world, you will not be able to trade with hindsight. Just because waiting until prices dropped to $96 happened to yield better returns doesn’t necessarily mean that was the right thing to do.
Why is scaling useful in the derivatives market?
Derivatives are securities whose values are indirectly determined by an underlying asset. Futures contracts and options contracts are two of the most common forms of derivative securities. Because these contracts are sold along a spectrum, rather than at a universal market price (like stocks), the principles of scaling can be applied even further.
A call option gives traders the right to buy at a specific price at a specific point in time. There are multiple ways that a trader can scale into a derivatives position. They might begin by purchasing at the money call options, allowing them to sell at $100. If prices begin to drop, they might scale in by purchasing call options for $98, $96, and $94. At the same time, they might instead keep purchasing $100 call options, increasing their exposure and hoping for larger returns.
Scaling derivatives is an extremely popular strategy because it affords traders the greatest amount of flexibility. No matter what directions markets may be moving, they will have the ability to either increase or decrease their exposure to risk. Options contracts, for example, can be adjusted for price, calls versus puts, and their expiration dates.
How can I develop an effective scaling strategy?
To develop an effective scaling strategy, begin by trading on paper. With experience, you will be able to see which approaches are most effective and most in line with your risk tolerance and other trading constraints. If you are willing to scale with positions of different sizes, your flexibility will increase even further.
Using varying stop orders is one of the easiest ways to scale “automatically.” Scaling is something that can be done in any speculative market. Remember, you are the one who controls the size of your positions and controls your overall exposure to risk.
Scaling is an innovative strategy that makes it possible to control your exposure to risk and potential for strong returns. By easing into and out of a potential position, you will have multiple exit and entry opportunities. Though scaling cannot guarantee you will earn returns on every position you hold, it is one of the most effective tools in a trader’s toolbelt.