Folks,
Its been a long time since I posted in TJ and thought of sharing something. There was a question that always comes into any trader’s mind – All out or scaling out is better as an exit strategy. Was going through some old emails and found this one. This conversation happened between me and another trader when we both were trading emini S&P back in 2007. It was an email conversation in a group and bear with me for this long post !!
***********************
Jonathan: Hey Madan – According to you, scaling out is better than all out as an exit strategy?
Madan: If you scale out, you really have multiple trading systems that happen to have a common entry point. Since each exit would have a different risk/reward ratio, you should evaluate each of them separately.
You certainly can scale out, just don't evaluate it as one system. It's not.
Richard :
That's an interesting way to look at it. I'm going to have to think about that.
However, I don't agree that multiple exits are separate systems. The all-in, scale out methodology isn't about being right or wrong - it's designed to deal with the fact that the outcome is uncertain. The method can be evaluated in total by looking at the frequency of each of the outcomes: max loss, first target only hit, first and second target hit, etc.
Madan: Lemme put it in a different way then…For example, on a momentum play with 3 contracts, having two quick targets makes sense because the play is a fast propulsion play on a breakout. With the third contract as a runner, bringing the stop up to breakeven makes very little sense to me. To be going after runners, you are entering a trend trade of the Donchian breakout variety(for eg
, which requires much larger stops in order to ensure that you catch the trend!
As I have the ability to backtest most of the trading ideas using automated strategy testing, the obvious back testing approach is to investigate the parameters of the quick target trades separately from the runner trade. It becomes clear that the optimizations are different for the runner than from the quick target part of the trades. I am not saying that scaling out method is not profitable, but I am suggesting that splitting the trade into its two separate components may make more sense, and possibly lead to greater profits
Jonathan: Agreed Madan. Nothing is right or wrong. It is just a trader’s comfort level with the exit management.
Madan: Jonathan - When you look at trading strategies/systems empirically you see that
(1) scaling out smooths out the equity curve, it does not necessarily make more net profit
(2) holding a full position for a winner and keeping the initial large stop can produce large net profit, but it requires a very strong "psychological constitution."
Think about, most trend following systems are 40% profitable trades, 60% losers, with a profit factor of 1.6+ That means statistically, you have to be able to stick with the system or strategy through 10-15 repeated stop outs to get those1-2 runners. If you fail just one time to execute on a trade setup and that one would have been one of your runners, you are setup for an even worse draw-down.
Richard: Well, here is the link from Van tharp’s website (some link about why scaling out is not better)..Apparently, Van says scaling out gives more mental satisfaction than financial sense.
Madan: I believe that both Tharp and Link make the same argument regarding scaling out, but they also make the point that the trade entry is not nearly as important and the exit. They tend to focus on strategies that have a defined risk, and a defined target or specific exit that they can back test to some degree. Take for example the opening gap trade. The entry is somewhat undefined, but the exit is not. If you can back test an opening gap strategy with a defined probability of the gap closing, then Tharp is right, scaling out will reduce your profits without reducing or losses.
With few exceptions, most of the strategies seem to be focused in the entry, with an unknown target. In my opinion, it's the exact opposite of what Tharp recommends in his books (if I remember correctly, it been a few years since I read it), and it would make sense why he would recommend against scaling out.
I am also writing a strategy that is entry focused with unknown targets and optionally scales out. I have found that the part of the position that is scaled out needs a separate exit strategy rather then just a fixed target. Otherwise, the additional risk of that additional contract does not pay for itself when you are stopped with a full position. So in fact, it is two separate strategies with a common entry. While scaling out reduces the strategy max profits, it also reduces the draw downs, which allows me to trade more contracts.
I think the choice may be summed up as:
- If your strategy is focused on the entry, with unknown targets, then scaling out makes sense. It will reduce your draw down (and your max profits), but allows you to increase the number of contracts you can trade.
- If your strategy is focused on reaching a specific exit, and the entry is less important, scaling out does not make sense. It will reduce your profits and increase your draw downs, requiring you to reduce the number of contracts you trade.
I think it's that simple.
*****************************
