From the July/August 2013 issue of Futures Magazine • Subscribe!

Scaling into reversals to gain an edge

Scale play

When a trader plans to scale into a long position in a falling market, it sometimes immediately reverses up after his first entry. Then he often will buy more as the market goes higher. This is scaling in at higher prices. A trader also can add to his position at a lower price if the market continues to fall after his initial entry.

Anyone who scales into a trade must have a plan to exit with either a profit or a loss, and trade management is a critical component to all profitable trading. When trading with or against a trend, a protective stop is important. You need to be aware of your maximum risk. If you are willing to lose up to $600 on a trade, structure every trade so the maximum loss is $600. This is per trade, not per contract. So, if you are willing to add to a trade two times as you scale in, the total loss on the entire position must be under the limit.

For example, if buying one E-mini S&P 500 contract, with a plan to scale in lower, and the initial stop is six points below this entry, the risk is $300. If the trader buys a second contract three points lower, he risks $150 on that second entry. Now total risk is $450. If one more contract is purchased when the market falls two additional points (five points below his first entry and two points below the second), $50 is risked on this contract, making total risk $500. This is acceptable because it is less than the maximum tolerable risk of $600. 

Many signals can be used to add additional contracts. Some traders simply scale in at predetermined steps. Others will use price action signals. For example, a trader might plan to buy the second contract if any decent buy signal forms at least three points below the original entry. An obvious signal is another reversal up, but at a lower price. An aggressive trader even will buy the close of a big bear trend bar as long as the reversal premise still is intact. Because the trader expects the bear breakout to fail and the market to reverse up sharply, a strong bear close gives him an opportunity to buy at a better price with limited risk.

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