Ed Note: This article is Part 2 of a series of 6 articles on price action trading. Click here to read the first part: Price action trading: The basics.
A trader often loses money because he takes a trade with one goal and manages it as if he entered with a different goal.
For day traders, this usually happens because the trader entered anticipating a subsequent price swing, but instead he managed the trade like a scalp. For example, say the trader shorted the EUR/USD in the forex market at what he thought was a strong top. He was planning on holding for a 100-pip (tick) profit, while using a 20-pip protective stop, but instead the trader exits whenever he had a 10-pip profit (ensuring he will lose money over time).
The trader might consistently convince himself that the price action unfolded differently from what he expected, and this change in his premise justified changing the trade from a swing to a scalp.
However, if he does this with frequency, he will lose money. A swing trade usually has a low probability of success, but the expected reward is many times greater than the risk, and that creates a positive Trader’s Equation. However, if the trader instead accepts a profit that is not much bigger or less than his risk, he will lose money over time with low-probability trades, which most swing trades are.
If a trader changes his mind and grabs a scalper’s profit, he is scalping, not swinging. Plug some numbers into the Trader’s Equation. A typical swing setup has about a 40% chance of success. If the trader is risking 10 pips to make 10 pips, he will lose money. To make money on a scalp, a trader needs a high probability of success (60% or more) because his reward is usually about the size of his risk.
At any instant in any market, a trader can trade profitably by buying or shorting for a swing because the probability of success for a profitable long or short is rarely ever less than 40%. This means that if he manages his trade correctly and holds for a reward that is at least twice as large as his risk, he will make money over time. Traders should only scalp if the probability is 60% or higher. Most traders cannot consistently maintain this high a probability and therefore should swing all of their trades. (My definition of a swing is any trade where your intended reward is at least twice as big as your risk.)
Some experienced scalpers win more than 90% of the time, but this is rare, and usually involves scaling into and out of positions. Many experienced traders scale into trades to increase the probability of their position’s success (see “Improving your odds,” below).
However, beginners should be careful about this because they almost always scale into the wrong trades. A common example is scaling into what they believe is a pullback when they do not realize that it is actually a reversal. They can quickly lose far more money than they imagined was possible, but that makes sense; if you are trying to get more probability, you have to pay for it with some combination of increased risk or reduced reward.
Two 2013 articles in Futures highlight scaling into trades: one for scaling into trends and the other about scaling into reversals. You can find them in the Futures archives.