From the May 2013 issue of Futures Magazine • Subscribe!

Beating uncertainty by scaling into trends

Assume that our trader finally decided on the high of bar 12 that the market was going higher and he bought them, which turned out to be the worst price. If he is comfortable risking $1,000 in the E-mini, how big a position should he take? It depends on the game plan, for example, if the trader is going to scale in on a pullback before the market reaches whatever profit target he has. At the moment, the trader believes the market is going higher as long as it stays above the bar 3 low. This is because a bull trend has higher lows and pullbacks need to stay above the most recent higher low. The trader then puts in a protective stop at one tick below the bar 3 low, risking 4.75 points, or about $240 per contract.

One approach is to buy four contracts. This would keep risk to about $1,000. Our trader is confident in the profit potential and therefore believes that the probability is at least 60%. Given this, reward must be at least equal to the actual risk. (When success is less certain, which is most of the time, traders should target a reward that is at least twice their current risk.) Once the market reached a new high at bar 22, the trader would raise the stop to below bar 19, the most recent higher low, and a profit equal to the actual risk would be necessary. The trader now knows that the actual number of ticks to risk to stay in the trade was to one tick below bar 19, which was 10 ticks or 2.5 points.

The scale effect

The trader’s equation is the basis of every trade that all successful traders take (see “The trader’s equation: Should I take this trade?” March 2011). The probability of success (here 60%) multiplied by the profit target (yet to be determined) must be at least as big as the chance of a loss (here 40%) times the actual risk (here 2.5 points).

Because the trader needs a reward at least as big as the risk, part or all of the trade could be exited at 2.5 points above the entry price. This is the profit target. Although not shown in the chart, the high of the day was exactly at this goal, which likely means that a lot of computers employed this same calculation to take profits here.

An alternative approach is to scale in lower. Experienced traders would recognize that the rally to the bar 12 high was not strong. There were no consecutive big bull trend bars; most of the bodies were small, the tails were prominent and there was a lot of overlap between adjacent bars. This suggests that even though a second leg up was likely, so was a pullback. The day probably would be either a trading-range day or a broad bull channel, both of which have pullbacks. With that in mind, a trader might have bought only a small position at the bar 12 high just to capture part of the trend in case the market continued higher without pulling back. The plan would be to add on if the market pulled back after entry, which it did.

There are many ways to structure a scale program, but the common element is to maintain an exit plan. In “Risk balance” this came into play if the market fell below the bar 3 low. As long as a trader structured a trade so total loss was under $1,000, or 20 points if the stop was hit, and the profit was as big as the actual risk, the plan would be mathematically sound.

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