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Book: Kane Trading on: Trading ABCD Patterns
Kane Trading on:
Scaling Out of Trades

Warning: As with many of my articles, this one may shatter your closely held beliefs, challenge the current 'status quo', and inspire you to think critically in a manner that you find uncomfortable. Read on only if you can handle this!
Like many of my recent free articles, this one, too, has been mostly written up, waiting to get 'cleaned up' and published. I have two other articles that I have discussed elsewhere that were 'in line' before this one. I decided to jump this one up the priority list because I have been getting questions lately about the topic, and I have recently seen some posts on it, so I felt I'd rather get this out there next.
Before we start, let me mention that although the title refers only to scaling out of trades, the general principals apply to scaling in to trades also. I neglected to put that into the title because, at this time, my own work is mostly with scaling out of trades. With that clarified, let's begin.
Over time I have heard many comments about my work. As I have discussed here and there I have had people tell me they love all of my work, except using entry techniques. These are the 'fader' crew, who love to just take a trade as it hits an area. This isn't the place for me to reiterate my views on why I require an entry technique for my own 'Trading Plan', as that is way out of the scope of this article.
My point is that sometimes I get feedback as to why someone is going to use their own ideas for a certain aspect of their 'Trading Plan'. Generally, I like to point out why I came to develop what I did for that aspect of the plan. I want people to know what my reasoning is for coming to the conclusions that I have, so that they can truly understand as much as I possibly can get them to understand about the underlying principles. As time has went on, I have had more and more comments about scaling, and that is what I wanted to address in a 'formal' article.
As everyone likely knows, I like to point out what I consider 'myths', and present serious food for thought on various topics. I don't seek to 'prove my point', only to show potential alternate ways to think about something, and hopefully that will contribute to people trying to think critically about the things they read, the conclusions they draw, and the beliefs they hold. Such a topic is scaling in and out of trades. I didn't realize this when I started writing on the topic, such as in Kane Trading on: Trailing Stops, and Kane Trading on: Trade Management, as well as in the free commentary, and so on.
One of the aspects about scaling is that it has been discussed from the viewpoint of many 'scientific', or should I say mathematical or statistical, studies. Hence, the conclusions are presented as definitive, clear-cut, or irrefutable. I have heard many people say things like 'Of all the things you don't want to do, this one is at the top of the list', and 'Statistically, you will make more money not scaling out of a position, and this has been clearly proven from studies'. What does Jim think? I disagree.
Let me mention a few things before we continue. My background is heavy in mathematics (including probability and game theory), with graduate work in there. I don't say this to sound like I think I'm something because of that, or to say that because of that what I say is gospel. I am simply pointing it out to say that I am not without mathematical skills when I draw my various conclusions.
Also, I am not going to try to refute the claims of studies on scaling with studies I have done, or published (note that most sources mention the studies, but never actually do cite any specifically). I am going to present some logical food for thought concepts that the reader can think about, and then draw his or her own conclusions from there. If one wants to stay with what they currently believe, I'm 100% fine with that. I simply want to present some other possibilities here.
I am going to cover two main aspects in this article. The first is a mathematical issue I have with the studies, and the second is a psychological aspect. In order for me to get into the mathematical aspect, I am going to digress into an analogy with moving averages, and hopefully I will be able to make my point as I transition back to the concept of scaling. Please bear with me as I unfold this digression.
We all know that a moving average crossover 'system' doesn't 'test out'. What that means is that over time it will not make money, no matter what parameters are chosen. I don't want to get too far off topic, so I will assume the reader understands what I mean here. You can choose pretty much any period in past history and find a choice of two moving averages and create a crossover 'system' that will be profitable, sometimes wildly profitable. This is the fodder of many dream merchants.
The problem is that there are a nearly infinite number of choices for the parameters, and perhaps only a few will 'work' on that data set. You change the data set and another set of parameters will 'work'. There seems to always be a few sets of parameters that will 'knock the cover off the ball', but the reality is that you can never know which few, of the many, it will be until after the fact. This makes it nearly useless information for the practical trader. Very interesting that there is a set of parameters, but next to useless for me.
Now, how does this relate to where we are going right now? I am going to make a bold leap here that will make many people uncomfortable. I can't 'prove' what I am about to say, I am simply going to state my opinion, based on my experience with mathematics. Feel free to disagree if you want. Although I agree that there surely is a technique to close a position in one shot that would show more profit, used solely by itself, than any scaling technique, I contend that you can never know what technique that is until after the fact, just like a moving average set of parameters. Wow, that has some implications.
Now, think about this for a minute. The entire basis for abandoning a scaling out approach is because mathematically it is not as efficient as a non-scaled approach. But the studies that 'prove' this have the ability to use hindsight in formulating the study. They take a data set, and then test various scaling techniques and compare them to one non-scaling technique, and they fall short every time. I don't dispute that mathematical observation. But what has that got to do with trading reality? I contend it has very little to do with it.
If I have no way to know, as markets change, and various market conditions present themselves, what the optimal single technique is, am I not in about the same boat as trying to use a moving average crossover 'system'? I have seen people discuss in various places ideas about how the market, at a given time, may be in various 'phases', like trending, sideways, doing these with or without volatility, and so on.
They discuss how one might change their techniques based on observing the current conditions. This doesn't even take into account a greater market condition that changes over time, as these various 'phases' exert themselves, like the effect of increased program trading or hedge funds, and so on. If one could know what 'phase' the market was in early on, one could use the plan that works best for that. But there is a problem.
This sounds to me exactly like the idea that one could just adjust the moving average crossover parameters to the ideal as soon as the market condition was known. Uh-huh, that will work. Sure. If that would work, the whole program trading world would do it, and arb out the edge. Back to the drawing board. I contend you will never be able to use that approach successfully.
What does this imply, to me? That the studies that rip up scaling out are nothing more than a mathematical curiosity to me as a practical trader. I will now move towards my explanation of why I think scaling has merit. I was listening to a discussion the other day about how this person had four 'systems', and they were each tuned to a different 'phase' of the market. He never knew what phase the market would be in, so he ran all four. When he tried to second guess the market 'phase' he was usually wrong, or late. His best real world results were from running all four.
I saw an analogy here with the idea of trading various commodities so that while one is in drawdown the odds of others not being in a drawdown were pretty good, and hence the equity curve was smoother. Yes, it would be the most efficient to trade just one issue when it was not in a drawdown, but good luck knowing what issue that is. And good luck knowing which 'phase' the market is in in time to make use of that, good luck choosing the right moving averages, and good luck, too, knowing which single technique is the best one to take off your entire position with.
I realized I didn't know which 'phase' the market was in, and which of my techniques was best at a given time. So, for the sake of this example, let's say I found four techniques, and each seemed to work best during a different 'phase'. Before we continue, let me mention that I am not strictly referring to four actual market phases, as I briefly outlined above, since I don't look at the market like that at all. I simply am trying to demonstrate that the market changes, and behaves differently throughout the day, and from day to day, and year to year. I simply can't tell in time what type of behavior it may have when I enter a trade.
If I trade all four techniques at once I perhaps get the benefit of smoothing out my equity curve, and although not being as efficient as having only the best technique on at that time, that's immaterial, since I can never known which technique that will be. To apply this to scaling, let's say I am in a single trade, using a single setup and such up to that point, but then I break it into four scale outs. Each is an independent technique, and is triggered by different factors in market price action. In the real world I feel this will outperform choosing any single technique for exiting.
So, can I back that up with studies? Absolutely not. As I have said many times, what I do is discretionary, and could never be 'coded' or 'back-tested'. I'm not even saying what I just presented is, in fact, better. I'm just saying I believe it to be, and that it is not so cut and dried as some very oversimplified studies make it sound. I'm not saying discount the studies, I'm just saying they aren't irrefutable 'fact' like they many times are presented to be. I am trying to show there may be another side to this, and hopefully people will start to think about that.
Now, before we move on the the second point, let me get into a little detail on something. Mathematically it might be argued that if one did choose a single technique, and just ran it regardless of the 'phases' of the market and the idea that it may be great at times, and poor at other times, it would perform equal to the blended technique I mentioned. I'll grant that that may be close to true. But, and I find this a big but, the drawdown should be greater, for reasons cited already about what blended trading of issues and systems have shown.
All thing being equal, I'll choose the smoother equity curve, not just for the psychological reasons, but also for the mathematical reasons that if an account is drawn down, it is harder to recover from than one that doesn't have that drawdown. And on top of this, the argument from the single exit people is that it is superior. The best real world argument I can see is that it might be equal with greater drawdown, which, in my opinion, makes it quite inferior.
Finally, we get on to the psychological issues. I recently saw a post that basically said the only reason to scale was to make one feel better, and they only would do that because they were psychologically unfit to trade, weak, wimpy, and so on. Well, let's jump from theoretical to real world here. Maybe this person was a 100% robot, able to execute perfectly under all manner of pressure, but most of us aren't. We are human, filled with frailties and imperfections.
Sure, it would be ideal if we could all simply not trade unless we could be machines, and operate at 100% efficiency, but that is not the real world. Are doctors or airline pilots at 100%, 100% of the time? Are you kidding me? This is a real world, filled with real people. Just because I can't operate 100% without any emotional realties to contend with doesn't mean I shouldn't trade, or be in business, or hold a job. Get real.
The point here? What if I had a choice between a methodology that makes me an x% return for the year, but because of my psychological makeup stresses me endlessly. Or I could use another methodology that returned me .90 x%, but I was very comfortable and efficient with it. It suited my personality, and my realistic human limitations. Hmmm, would I be weak if I chose the latter? In my opinion I'd be acting very smartly. People are human, and the best 'Trading Plan' is not always only chosen simply because the rate of return is the highest of all variations of the plan. And it in no way implies that there is anything 'wrong' with a person who chooses such a plan.
Now, how is this directly relevant to this topic? Well, what if a blended, scaled approach yielded a little less return, but had a much smoother equity curve, with less drawdown, and a person decided to choose that because the lesser return was a great trade-off with the much higher comfort level? Mathematically (using the studies, not what we have covered today), this makes no sense, right? Well, not accepting who you are and what works for you is a sure way to failure or burnout, and mathematically zero return isn't too good. Not taking into account the human factor, or saying only wimps would take it into account, is no way to proceed if you want to succeed at this long-term, in my opinion.
So, what do you think? Are you thinking now? I've developed quite a reputation, one which I am very happy about, for presenting the other side of many issues. I don't like biased or one-sided presentations. I don't care what people decide, and I have no axe to grind, I just want people to see both sides so that the decision they make is informed. We have far too much one-sided information out there, and far too many people citing studies and ideas and not blending in common sense. The emphasis on 'scientific' is so great it supersedes the use of critical thinking and common sense.
I know this is controversial, and many want to just stick to the numbers from oversimplified studies. Heck, don't you recall the studies that 'proved' the market is random? Where are they now? I've been down the academic and 'scientific' road, and I'll take, personally, critical thinking and common sense over 'studies' any day of the week. I'm not asking that everyone do that, only that you at least look at what the other side looks like when you make your assessments in the real world. If I have convinced people to do that, this time here was well spent for me.
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