From the May 2013 issue of Futures Magazine • Subscribe!

Beating uncertainty by scaling into trends

Assets at risk

Scaling into a trade is directly related to how much you risk on any given position. Determining your position size is based on a combination of factors, including the market you’re trading, current volatility, trading strategy, your other investments, net worth, penchant for risk and desire for reward. However, a good rule of thumb is a relatively simple one. Trade the “I don’t care” size. In other words, trade a position size that is so small that you don’t care much if you lose. This will allow a much better chance at remaining objective and doing the right thing. Invariably, beginners tend to enter and exit either too early or too late, and their decisions usually are prompted by emotion.

The I don’t care size is much smaller than what most traders risk. For most, this is less than 2% or so of their total risk capital on any trade. If you think you can comfortably trade 10 E-minis, then you probably should trade only two or three. If you think that you can trade 1,000 SPY shares, you probably should trade only 200 or 300.

A trader might ask, “How do you expect me to get rich if I trade so small?” The answer is simple. One of the first steps to getting rich is to remain objective, and you need to trade small so you can do what the market is telling you to do, not what your anxiety and greed are making you do.

Markets and sizing

If a trader is new to scaling into a position and wants to minimize the total dollars at risk, a reasonable alternative to trading the E-mini or the SPY is to trade weekly SPY options. For example, if a trader wanted to scale into a long position, he or she might buy one at-the-money (ATM) call. If a call is purchased on Monday, it has five days to expiration and it might cost 0.90, or $90. If a trader bought the call on Friday, the day it expires, it might cost $30. Even if that $30 call expired worthless at the end of the day, the total loss would be $30 plus about $1 in commissions.

The weekly SPY options are liquid and the bid-ask spread of the ATM call usually is a penny. There are many trades every day of 1,000 or more calls. Trades of 5,000 or more also are common. An individual trader does not have to worry about getting too big for this market.

For the sake of the example in “Risk balance” (below), assume that a trader comfortably can trade 10 E-mini contracts and is willing to risk two points per contract. That means he’s willing to risk $1,000 (plus about $50 in commissions) on each trade. The five-minute chart has 81 bars during the trading session, and the numbering reflects this (for example, bar 12 is the 12th bar of the day). The market reversed up at bar 3, and bar 7 was a small breakout because its close was above the high of the prior bar, creating an intraday gap. Gaps like this are important because they are a sign of strength, and automated trading systems often treat them as measuring gaps and look to take profits at a measured move up.

By the close of bar 8, most traders assumed that the market was going higher, even if there was a pullback. The predominant assumption is that any pullback would remain above the bar 3 low where the trend began. At this point, the market was “always in long,” which means if a trader had to take a trade at this moment, long or short, only long trades would be considered. Bulls are buying for every conceivable reason, and many have limit orders below the current market price to add on or to get long on any pullback.

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