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Old 08-05-2007, 11:34 PM   #1

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Trading with Market Statistics VI. Scaling In and Risk Tolerance

In Part V of this series on trading with market statistics (click here for Parts I,II,III, and IV), I posed the question in the video about what TRADER should do if upon entering a trade at the 1st SD, the market should move against him. I suggested that based on the data given there was only 1 correct answer. That answer we will now discuss in this thread.

Before we address the answer, we need to discuss a related topic called risk tolerance. First what risk tolerance is not. It is not a stop loss that you set for each trade based on some support or resistance point you arbitrarily choose on the price chart. More often than not, this kind of stop loss is in the wrong place. These stop losses are not based on market volatility, but rather on some price point that "looks like it ought to hold", usually some local minimum (for long trades) or local maximum (for short entries). That they are wrong probably accounts for the large number of losing trades that new traders have. Unfortunately, most trading books tout these stoploss points as if they are written in stone. Phrases like, "you should only enter a trade such that your reward/risk ratio is 2:1 or greater" forces the trader to choose a stop loss which has nothing to do with the known volatility of the market.

So what should you as a day trader do about stop losses? Well for starters, you should set a "system stop". This is an in the market hard stop far from your market entry which protects you in case of system failure (eg, your computer crashes, you cable modem dies, you lose electric power in your neighborhood, etc.). It has nothing to do with the trade itself. Any other stop you wish to use you keep in your brain as a mental stop.

And where is this mental stop? Your mental stop should initially be a percentage of your account. Typical values bandied about range anywhere from 1% to 2% of your trading capital. So if you have a 50K account, you should be willing to risk up to 1K on every trade. The mental stop is flexible, it won't increase, but it certainly can decrease depending on the price action. For example if the price action makes the trade profitable, your mental stop can become a hard trailing stop.

TRADER is now about to have a second epiphany. He is about to realize that by using risk tolerance instead of some fixed stoploss, he will be able to scale-in to a trade and not feel any angst about it, if the scale-in is within his risk tolerance limit.
If it is not within his risk tolerance, then he should not have entered the initial trade to begin with. TRADER should always have a plan to either scale-in or to reverse a trade (to be discussed in a future thread), and the scale-in price should be a point where he could have taken a trade in the first place.

Risk tolerance and scaling in may make you feel queasy, because it requires a paradigm shift in your thinking about what trade management is all about. It is not about setting fixed stoplosses and profit targets and then sitting back and watching. It requires your active participation. Like the baby bird who is kicked out of the nest and told by its mother to either fly or die, if you are losing money from stoplosses and your account is slowly bleeding, you need to find a better way.


Now that our trader has some idea about risk tolerance, what does TRADER do when after his 1 contract entry at the 1st SD, price action takes the market backup to the VWAP rather than down to the 2nd SD? In the old paradigm of using fixed stoplosses, he probably would have been stopped out. In the new paradigm of replacing stoplosses with risk tolerance, you know what he has to do! He's done it many times before. The market is still skewed to the downside, he normally takes short entries at the VWAP. So why not this time? Indeed why not? TRADER pulls the trigger a second time and enters with a short at the VWAP because he knows that his risk tolerance is still quite large. He is now 2 contracts short. This is called scaling in. His expectation at this point is that the market will move back down to the 1st SD. Is this a reasonable expectation? Yes! Nothing about the volatility has changed. The SD is still where it was before the 2nd entry and that's the measure of volatility. Nothing's changed. TRADER should feel confident in pulling the trigger a second time. He is going to actively manage this trade. He still has a mental stoploss at his risk tolerance level. Where is his profit target? He has three choices now that he is short 2 contracts: 1) He can take 2 contracts off the table when price action hits the breakeven point-1 tick, 2) take 1 contract off the table at the break even point-1 tick and the 2nd contract off at the 1st SD, 3) hold both contracts and exit at the 1st SD. In all cases he ends up with a profit instead of a loss. Watch the video and see how TRADER manages his trade.

Scale-in Video

What TRADER did in the video is of course controversial (For previous discussions on this topic see the thread "Doc, my passion gives me much stress" beginning at post 13916 where Dogpile expounds upon his firm belief in hard stops and my response. Also the discussion in the thread "Scaling In and/or Out" where I discuss the difference between scaling in and averaging down (or up for short trades) beginning at post 13142.

Controversial or not, it is my firm belief that a trader needs to understand what scaling-in is all about. I personally didn't become profitable until I understood this and I use it as one tactic in my trading arsenal. If stoplosses are bleeding you, then consider this new paradigm.
Attached Files
File Type: swf NQscale_inJuly25.swf (8.04 MB, 4419 views)
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Old 08-05-2007, 11:36 PM   #2

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Re: Trading with Market Statistics VI. Scaling In and Risk Tolerance

If you have followed the details for scaling in, you should be able to answer the following questions. Take a shot at them and post your answers here

1)Assume your account is 50K and that you have a risk tolerance on any trade sequence of 2% of your account including commissions. A trade sequence is a group of related trades involving scale-ins and scale-outs and/or reversals (which we haven't discussed yet).
Let's say you trade the Emini Russell 2000 index futures where 1 tick is worth $10 (0.1 points) and your roundtrip commission/contract is $5.00. You enter a 1 contract trade long at the 2nd SD, but the market moves against you back down to the 1st SD where you scale-in another contract long. The market is relentless and it continues to move down to the VWAP where again you scale-in an additional 2 contracts long. Again the market continues it relentless move down. You finally hit your risk tolerance at the 1st SD below the VWAP, so you exit your entire trade and are flat.

Question: What is the value of the SD in ticks?

2)When you scale-in at the VWAP in the above scenario, the market finally rotates and starts moving back up. You exit the entire trade at break even +1 tick.

Question: Where is your break even point including commission measured in ticks above the VWAP?
How much money did you make on the trade?

If you were able to answere these questions without too much difficulty, then you are ready to become a full time trader with all the rights and privileges granted thereto. You are also ready for part VII
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Last edited by jperl; 08-19-2007 at 02:48 PM.
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Old 08-06-2007, 12:37 PM   #3

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Re: Trading with Market Statistics VI. Scaling In and Risk Tolerance

I will reply while I have a minute:

50K Account
2% risk = 1k
1K = 10pts
4 contracts commission = .2 pts
Point risk = 10-.2 = 9.8

1) Let x = value of SD in ticks

Loss at 1sd below VWAP for long:

9.8 points = 1 * 3x + 1 * 2x + 2*x
ANSWER to #1
x = 1.4pts or $140 risk/contract/SD

2) Exit at breakeven + 1 tick

What is total loss at VWAP?

2nd SD entry = -2x = -2.8pts
1st SD entry = -1x = -1.4pts
VWAP = 2(0) = 0 pts down

Now you have 4 contracts and you are down 4.2pts
add in .2pts for commission to get be pt total = 4.4pts

Let x = the number of pts you need to get to b/e

4x = 4.4
x = 1.1points above VWAP to b/e on 4 contracts

An exit 1 tick above b/e would give you .1 pts on all 4
so .4 points = $40

Hopefully that is correct, so it needed to move less than
1 SD for you to b/e. SD is 1.4 pts and b/e + 1 was 1.2 points.

Jerry, I really am learning alot. Totally different from all the books
courses, systems and everything I have been taught. Very interesting. Although I am still in a quandry as I realize now that I can't follow along without having PVP on my charts. On that side it is a little discouraging as I am really short on time to develop a volume distribution indicator at this time.

One thing I like...it allows you to profit in 2 out of 3 scenarios:

1) The market moves your direction right away
Dont make as much money as you have 25% of a position on
relative to a loss where you have 4 contracts on

2) The market moves against you (1 or 2 SD's)
You make money and you could have 50% to 100% of position on

3) The market moves to opposite side of SD and you get stopped
And it really hurts because you lose on average alot more than
you make when you are correct

I love your ideas you are presenting but it seems the risk reward in my terms that I am used to thinking about will really hurt when you do get stopped out.

Thanks for sharing a new way to approach the markets,

dbntina
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Old 08-06-2007, 02:27 PM   #4

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Re: Trading with Market Statistics VI. Scaling In and Risk Tolerance

Hey Jerry, pardon my laziness to look back older threads but did you ever mention how you familiarized yourself with this method? Is it of your own creation, or did you learn it from somewhere? Any books or reading material available on the subject? I am very pleased that you are helping us with this invaluable knowledge, thank you so much!
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Old 08-06-2007, 05:43 PM   #5

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Re: Trading with Market Statistics VI. Scaling In and Risk Tolerance

jerry, was curious if this is true or false:

given your assumption that SD will be generaly understated for any skewed distribution and therefore trading at the +1/-1 SD level will generally be profitable since it will be likely to go 2 SD's (if skewed) enough times to offset your stop outs... then would it hold that every tick closer FROM +1.0/-1.0 StdDev TO the VWAP is superior location to the point of exactly +1.0/-1.0 Std Devs... seems intuitive that this would be the case and if so, it begs the question why trade necessarily at the +1.0/-1.0 std dev... if any entry superior to that level is also expected to be profitable then there is something to be said for improving location relative to that level through some technique/filter that adds a little value to that, ie X ATR's better than the +1/-1 Std Dev price where X can probably be calculated through back-testing to give you the most number of trades that are still profitable enough to offset the extra variance they create.

I got the sense that you were just trying to increase the number of trades and picked +1/-1 std dev as a number that seemed to have some logic to it. but I didn't 'get it' if there was another reason why this price was important. you did say 'for any arbitrary distribution...' so I assumed you were saying that the expectation is for an artitrary distribution to develop and you have no expectation as to how it gets there -- such that VWAP price is superior to +1/-1 std dev and +1/-1 std dev is superior to +2/-2 std dev's and therefore; (-1 std dev + 1 ATR) would be superior location for say, a short, than; (-1 std dev), is that right?

if I am not right about the above assumption, can you explain why that is?

Last edited by Dogpile; 08-06-2007 at 05:46 PM.
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Old 08-06-2007, 06:39 PM   #6

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Re: Trading with Market Statistics VI. Scaling In and Risk Tolerance

Sorry this isn't directly on topic but for tradestation users who are trying to follow Jerry's methodology I have a question.

I have coded the VWAP, SD bands and PVP on a tick by tick basis on a 1 Tick chart. I was thinking I could simply hide the 1 tick chart and plot the indicators on a 2 minute chart and everything would be cool...problem is that it gives me an error "Tick and Volume intervals cannot be used in a mult-symbol chart".

Does anyone know of a way around this to plot the data gathered from the 1Tick to plot on a minute chart? There has to be a way around this. Maybe creating a function and access...I don't know just thinking out loud...like I said I am new to the functionality of TS and need help.

I will post for all TS users for free if we can get this thing figured out.

Thanks...and sorry to but in on the thread but though this could help TS users follow along.

Any help is appreciated. This should be the fix that NICK was pointing out for accuracy in the indicator thread.

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Old 08-06-2007, 07:17 PM   #7

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Re: Trading with Market Statistics VI. Scaling In and Risk Tolerance

Quote:
Originally Posted by dbntina »
Does anyone know of a way around this to plot the data gathered from the 1Tick to plot on a minute chart? There has to be a way around this. Maybe creating a function and access...I don't know just thinking out loud...like I said I am new to the functionality of TS and need help.
dbntina,

you may want to look into the All Data Everywhere (ADE) DLL/function set on the tradestation forums. Apparently, it allows you to send receive data from chart to chart, without the time/tick restrictions you mentioned. I haven't had time to delve into it myself, but I think it's exactly what you're looking for. Here is a link to the ADE FAQ on the tradestation wiki:

https://www.tradestation.com/wiki/pa...on?pageId=8975

Hope it helps.

-Luis
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Old 08-06-2007, 10:53 PM   #8

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Re: Trading with Market Statistics VI. Scaling In and Risk Tolerance

Quote:
Originally Posted by jperl »
TRADER should always have a plan to either scale-in or to reverse a trade (to be discussed in a future thread), and the scale-in price should be a point where he could have taken a trade in the first place.
Jerry, I'm a little confused by this part. Maybe it would have to do with going reverse on the trade but say in that example you had waited until price had gone back to the wvap to even start the trade. Wouldn't you have not scaled in at the vwap and put on your full risk tolerance right away since that will be the highest probability trade you can get? I also don't see where above the wvap you would even want to scale in since if price had gone up to the pvp would'nt you have used that as your system stop?
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