Professional traders seldom do “all or nothing” trades, in which an entire position is entered at once. Amateur retail traders make the error of entering large positions with single trading decisions, which can cause costly stops, and missed opportunities. Unsuccessful traders often make the cardinal error of adding to losing positions, which can be disastrous for trading accounts.
Let’s look at how experienced traders manage their trades, using a series of incremental trades, that build into winning positions while minimizing the costs of stop-losses.
Keeping Out Of Trouble: Starting Off With Small-Size “Pilot” Trades
The first rule when trading is to minimize the cost of errors, with small stop losses. The best way to accomplish this is by starting off trades with small size (for example, entering trades with an initial share size of just 20-50 shares, instead of 100-1000 shares or more), and diversifying by entering more trades with smaller size, rather than just a few trades with large size.
Managing risk by starting off with a handful of these small-size “pilot” trades also builds trader confidence, because there’s not as much worry about the cost of being wrong. If for example a 20-share trade goes against the trader by 1 point, that’s a $20 (plus commission) stop loss, which is smart, compared to starting with a 200-share trade, which if it goes against the trader by 1 point would cost $200 (plus commissions).
So for example instead of allocating capital to just 8 or10 larger-size positions, it’s often more effective to instead trade 20-25 smaller-size positions, across various strong sectors, to capitalize on strong moves. Whether swing or day trading stocks or exchange-traded funds (ETFs), it’s smart to “scale in” to trades by starting with small size, then adding to those that are successful.
How to Scale Into Winning Trades
Although it limits initial profit potential, small-share entries also limit stop-loss costs, which is critical (especially for new traders). Consider Figure 1, [Starbucks (SBUX)] for a stock swing trade example. A series of trade entries are made above each new “cup” breakout (a cup looks like the letter U and indicates buying strength above the cup’s high). In the case of SBUX, that would be at 49.7 and again over 52.5, with a stop loss set at the breakeven point (which in this case would be around 51.2).
The goal is to add to that small percentage of winning trades incrementally. One guideline is to set a specific dollar figure that a trade has to be “in the money” by, before adding to it (such as “it has to be in the green by at least $120 before adding to an open swing trade”). By focusing your efforts on that small handful of winning trades, and adding to them sequentially following continuation breakouts, it’s possible to “build a position” over time that is very successful.
How to Exit Winning Open Trades
If the chart drops from here, the hard stop gets the trader out at breakeven, as the goal. If it continues up, then another trade could be entered following another cup breakout. And so on. Typically trades may move for up to 2-4 “scale-in” trades before pulling back, which is ample time to scale into a winning trade before a reversal occurs.
In practice, a trader may find that many trades either cause small initial stops, or get “breakeven trades” because after a second position is entered, a reversal will pull the price back to even. It’s the ones that do continue up that account for the biggest gains in a traders’ account. This may be just a small percentage of overall trade entries (10-30%). That’s fine.
By combining careful, strategic trade management tactics with entry pattern recognition skills, traders can plan on how to exit trades in a way that leads to one of 3 potential outcomes: 1) a small stop, 2) a breakeven “scratch” trade or 3) a moderate win, after scaling into a 2nd and possibly 3rd or even 4th trade, that’s continuing in-trend.
Also, by initiating new trades on small size, that also mitigates the risk associated with gaps against the trade, since the initial share size is small. Exiting at the first sign of trouble (for example, under a two-day low, for open long swing trades), is instrumental in protecting open profits.
Another example can be found in Figure 2 [Sears Holdings, (SHLD)], in which sequential cup breakouts clearly indicated how to “scale in” to a position, over the 66.0 and again over the 72.0 for adding to winning open long trade positions.
By starting everything off small, and skeptically considering it a “test” trade on new high breakouts (for longs), a trader can adopt a more professional approach. Keeping risk as small as possible while building winning trades over time, with a series of several entries (compared to a single all-or-nothing trade), is a much smarter, conservative way to trade the markets.
Tip #1: Set a fixed amount of capital to initiate each trade, no more than 1% of your total capital account (for example $300 for a $30000 account). While it may test your patience to trade small, it’s also a particularly effective “bounce back” technique to rebuild a portfolio that’s suffered serious drawdowns (in addition to being a solid approach for successful veteran traders as well).
Tip #2: Use 2-day lows (loss of prior day + current day’s low) as the absolute stop loss for stock and ETF swing trades, and no more than .08 to .4 for intraday trades. Most professional day trading stops are .04 to .12 or so in size, to keep things tight.
Tip #3: When adding to winning trades, build a ‘reverse martingale’, in which trade 1 is 1 unit, trade 2 is 1 unit, trade 3 is 2 units, trade 4 is 4 units and so on. For example, Trade 1 is 10 shares, Trade 2 adds another 10 shares to an open winner, Trade 3 adds 20 shares to the first shares, and Trade 4 adds 40 shares to the now-40 share position that’s been built (and should by now have an open profit of at least $150-$400 for a swing trade, for example). This makes all trades start small and “prove themselves” before the trader adds to their position.
Tip #4: Diversify widely, based on strongest sectors. If for example the Retail sector is strong, I’ll be trading stocks like SHLD, Target (TGT), Wal-Mart (WMT), and Costco (COST), and may have open small-share “pilot” trades in all 4 stocks. Or if stocks in the retail coffee sector are strong, I may trade both Starbucks and Green Mountain (GMCR). It’s important to build a mini-portfolio of actively traded stocks so that you are trading multiple instruments in strong sectors. This also build confidence because you’re not emotionally invested to any single position, but instead are “playing the field” to see which ones take a lead, that can then be added to.
Using careful risk management by scaling in to “build winning positions” while having plenty of small stops and breakeven type trades along the way is a more professional, strategic approach to active trading. Traders wipe out their accounts by adding to losing positions, overtrading choppy charts, trading too few stocks and ETFs on too-large initial share size, and letting losing positions continue against them. By using a more diversified, careful approach when trading, it’s possible to limit losses significantly, while taking moderate scaled-in gains off Wall Street.
Ken Calhoun is a trading professional who has traded millions of dollars of equities since the 1990s, and is the producer of multiple award-winning trading courses and video-based training systems for active traders. He is a UCLA alumnus and is the founder of DaytradingUniversity.com, a popular online educational site for active traders.
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