Almost everyone who has ever traded has scaled down into a trade at least once in his or her career - this is also known as adding to a loser. This very common mistake stems from the need to be proved right. The thinking usually goes like this: if you liked the EUR/USD long at 1.2000, you'll love it even better at 1.1900 - it's a better bargain! Of course, the market eventually teaches all traders the folly of such thinking. There are situations in which markets simply do not turn around, and profits accumulated through years of trading can disappear within days. Follow the scale down strategy long enough, and you will eventually go broke. Scaling down can be a valid strategy, but only when it is practiced with inviolable discipline - which, unfortunately, most traders do not possess. Far rarer than the scaling down strategy, yet potentially far more lucrative, is its exact opposite - scaling up. Among traders, scaling up is also known as "pressing the trade". In this article, we'll explain the strategy of scaling up, show you an example of how it's done and discuss the risks that come with this approach. (These trades rank among the all-time greats, find out who made them in The Greatest Currency Trades Ever Made.)
What Is Scaling Up?
The idea of scaling up into a trade is relatively straightforward. Instead of adding to a position as it moves against him or her, the trader would only add as the position becomes increasingly profitable. For example, if a trader went long EUR/USD at 1.2000, he would only add to his trade if the currency pair moved to 1.2200. On the surface, this appears to be an eminently reasonable course of action. It is what Dennis Gartman - investing guru and writer of the famous daily stock market newsletter "The Gartman Letter" - refers to as "doing more of what is working and less of what is not".
In fact, this strategy is as old as trading itself. Dickson G. Watts (who was President of the New York Cotton Exchange between 1878 and 1880) wrote about it as early as the 1880s, in the book "Speculation As A Fine Art And Thoughts On Life":
"It is better to 'average up' than to 'average down'. This opinion is contrary to the one commonly held and acted upon; it being the practice to buy, and on a decline to buy more. This reduces the average. Probably four times out of five this method will result in striking a reaction in the market that will prevent loss, but the fifth time, meeting with a permanently declining market, the operator loses his head and closes out, making a heavy loss - a loss so great as to bring complete demoralization, often ruin.
"But buying at first moderately, and, as the market advances, adding slowly and cautiously to the 'line' - this is a way of speculating that requires great care and watchfulness, for the market will often (probably four times out of five) react to the point of 'average'. Here lies the danger. Failure to close out at the point of the average destroys the safety of the whole operation. Occasionally a permanently advancing market is met with and a big profit secured.
"In such an operation the original risk is small, the danger at no time great, and when successful, the profit is large. The method should only be employed when an important advance or decline is expected, and with a moderate capital can be undertaken with comparative safety."
Why Isn't It More Popular?
So, why do so many traders employ scaling down strategies, while so few traders engage in scaling up trades? The key reason may be our innate predilection for bargain hunting. It is said that real New Yorkers never pay retail. And it is indeed true that many denizens of Wall Street will ruthlessly search out the best deals for anything from a cup of street vendor's coffee to a designer suit. However, this trait is as common among farmers in Happy, Texas as it is among investment bankers in Manhattan. Most people hate to "pay up", and that's the reason why they won't "scale up" into trades.
Nevertheless, scaling up can be an extremely profitable endeavor. Here is a description taken from TradersLaboratory bulletin board about how a very famous pit trader, Richard Dennis, employed just such a strategy with bond futures.
"As someone who has seen the likes of Rich Dennis and Tudor Jones operate, those '5%' winning trades involve add-on after add-on. Case in point is Dennis in the 1985-1986 bull market in bond futures. He would start with his normal unit of 500 contracts and get chopped for days. Buy the day's high, put 'em back out on a new swing low, etc. Every once in a while he'd wind up with 500 that worked. Then he'd start the process higher, all over again. Work 'em in, work 'em out. After maybe a couple of months the market has rallied 10 pts. from where he started, and he has 2,000 on (meaning 2 million a point). Now the market is short and ready to pop on any size buying, and he's there supplying the noose. Bidding for 500 on every uptick, he finally gets to a point where for the last month of the move he has 5,000 on. T-bonds rally 20 pts. In just over a month he's up $100 million on a trade that started out with him just testing the waters, losing $100,000 a few times before he could establish a position worth doubling up on."
One trade, $100 million dollars in profit. While most of us can never aspire to success on such an enormous scale, the profit opportunities for scale up trades present themselves to retail FX traders on a regular basis. Let's take a look at price action in the USD/JPY pair for a good example of this strategy in action.
Putting It into Practice
On April 24, 2006, a scale up trader would have entered a short on USD/JPY at 115.50, after the pair broke the double bottom support at that level, risking 150 points on the trade to 117.00. As the downside momentum accelerated, the trader would have added another unit to his or her position as it breached the 113.50 barrier on May 1. Finally, as USD/JPY careened through the 111.50 level on May 8, the scale up trader would have added yet one more unit, short building the position to three units. At the first sign of loss of downside momentum around the 109.00 figure, the trader would close out the position. At that point, the total profit on the trade would amount to 1350 points on an initial risk of only 150 points, for a whopping 9:1 risk/reward ratio!
Proceed with Caution
If you are a trader, you may be thinking at this point that scaling up sounds like a pretty good way to make a tidy profit. But before you rush to initiate scale up trade strategies, it is critical that you understand the drawbacks. While the scale up trade may indeed be very lucrative, it is also extremely rare. There is a reason why, in the quote about Richard Dennis, the person posting refers to the trade as a "5 percenter". Scale up trades are in fact successful only 5% of the time, if not less.
In order to work, scale up trades require two key ingredients: a propitious entry that becomes profitable almost from the start of the trade and a strong uninterrupted trend with virtually no retraces along the way. The description of the scale up strategy as "pressing the trade" is actually very apropos, because the trader is in fact pushing the position further and further as price action moves his or her way. Imagine a situation in which the USD/JPY trade did not go as smoothly as shown, but instead retraced back to 113.50 after the third unit was sold short at 111.50. The trader would then have to cover the position at breakeven, faced with the knowledge that a guaranteed profit of 600 points disappeared instantly as the scale up trade went awry. Unfortunately, this type of price action happens more often than not, as the strategy of "pressing the trade" often presses back on the trader.
For traders capable of withstanding the psychological pressure of losing massive open profits to the vagaries of the market, the scale up trade can be an invaluable strategy. Clearly, it has produced some of the greatest trading successes in the history of financial markets, but anyone who attempts this approach must prepare for many moments of failure and frustration. Imagine that you have worked on a complex jigsaw puzzle for several weeks and are within a few pieces of finishing it, when someone intentionally comes by and scrambles all the pieces. If you can accept such turns of events with quietude and calmly begin the assembly process once again, then the scale up trade may be right for you. (Find out more about scaling strategies in Pyramid Your Way To Profits.)
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