There seems to be no rhyme or reason to day trading if you’re not a day trader yourself. Indeed, the frenetic, nearly frantic pace of jumping into and out of stocks between the opening and closing bell can appear chaotic; a feeding frenzy of investors that seem to blur the line between making a sound investment and rolling the dice. Despite its outward appearance, there is an intricate art of risk management that experienced day traders can deploy throughout the day. The procedure is known as scaling, and it can be an essential component to helping the day trader potentially gain a profit – as long as it’s used wisely.
What is Scaling?
Scaling, or scaling techniques, is the term for the action of a day trader buying and selling stocks in minuscule pieces. These small purchases enable the day trader to have greater risk control. This can be tough to do on a large scale, as transaction costs tend to limit the technique for many day traders, particularly those that use discount brokers that charge a flat fee for each trade. However, there is no single magic number of scales that a day trader should aspire to as he or she moves in and out of position. That said, a good rule of thumb is to deploy two to three scales at a time in most scenarios.
The frequency in which scaling is used tends to correlate to a trader’s holding period for a particular stock. The trader that scalps is not going to use scaling too often, whereas a trader using position trades is going to have greater opportunities to do so. There are exceptions to this rule – particularly frantic day trading strategies may try to wedge more scaling into the mix – but the correlation between trading frequency and scaling frequency is usually constant.
Scales typically will be used to help day traders enter and exit positions with a minimal amount of risk. However, scales don’t always have to be part of both an entrance and an exit strategy. For instance, position traders can deploy scaling when a security’s base is being built. In this case, the scale would be added each time the security tests base support and when it breaks out en route to an uptrend. In this scenario, the investor would already have a predetermined exit strategy – that is, when the stock hits its reward target. In this case, no scaling correlating to an exit is needed, because things have already been figured out.
Benefits of Scaling Strategies
The upside to using a scaling strategy is that it gives short-term traders like day traders a greater measure of risk control than they would otherwise have. This is particularly the case when position trading strategies are deployed, as scaling works best when reward and risk targets are placed in advance. However, scaling strategies are still very much useable amongst the trend follower and momentum set, particularly when they’re broken into smaller pieces.
Theoretically, scaling techniques are great ways to keep investors honest. While scaling strategies can be used without a net if divvied into small pieces, they do perform at their optimal when used in conjunction with risk and reward targets. The reason for this is because it provides investors with an extra layer of security to let them know it’s time to jump in or bail out on a stock. This ultimately leads to smarter decisions when extrapolated into the long term.
When Scaling Goes Bad
When scaling is used judiciously, it can be a useful tool for the day trader or short-term investor to mitigate any potential losses. However, when it’s used recklessly, it could end up being a costly tactic that can have devastating effects.
For instance, if scales are applied to a portfolio of stocks, the stocks that perform the poorest will end up demanding the most capital as more and more purchase are made as the stock goes into decline. Furthermore, all money is automatically assigned to the portfolio’s most underperforming stocks while the best ones are sold off. For the trader that’s concentrating on the scales that are set for the winners, this re-setting of loser stocks could be the recipe for a massive underperformance versus the market trends. Eventually, this could be disastrous to the investor’s bottom line.
What’s more, the losing stocks that end up eating away at the investor’s capital could come out of nowhere. All it takes is news of a major shakeup or corporate disaster to turn the non-diligent scale-trading investor’s portfolio upside down. In the world of short-term traders, this could be particularly devastating if they eschew any form of fundamental analysis and solely stick to technical analysis because they theoretically won’t be as prepared to deal with a potential shakeup.
Is Using Scale Trading Worth It?
Scale trading has its fair share of critics, some of whom make no bones about their utter disdain for the practice. To the naysayers, the method feels too much like a scheme that feeds on the naïve investor that looks to the practice as a means to build gains lightning fast, only to learn the hard way that a big, bad loss can spell doom.
However, for the smart and savvy day trader, setting scales can be an effective risk management strategy, provided they act wisely as they set things up. This would include executing critical steps like setting up risk and reward targets and paying attention to the entirety of their portfolio’s overall performance. Limiting the number of scale traded stocks to a number they can handle both mentally and financially is an enormous step to take as well. While executing these steps won’t guarantee pure profit and no losses – no stock market strategy can lay such a claim – it may go a long way into helping you prove those that deride the practice wrong on some scale.