Scale-In Trading Strategy: Overview, Rules, Backtest Analysis
When it comes to trade entry and exit, most traders tend to think in singular terms — one shot in and one shot out. But breaking the position size into multiple smaller trade sizes and scaling in gradually may offer a better average entry price. Want to know about the scale-in trading strategy?
In trading, to scale in means to gradually build up your position size as the market creates more entry opportunities. The scale-in strategy is a part of a well-thought-out trading plan, rather than a reactionary attempt to salvage a losing trade.
The scale-in strategy enables more flexibility in terms of attaining the most optimal average price for positions, but it requires enormous discipline to stick to the plan when things seem to be falling apart. In fact, it is better implemented with a trading algo.
In this post, we take a look at the scale-in and scale-out trading strategies. At the end of the article, we make a backtest of how you can use a scale-in strategy.
What is scale-in?
But first, let’s look at what scale-in actually means:
In trading, to scale in means to gradually build up your position size as the market creates more entry opportunities. The scale-in strategy is a part of a well-thought-out trading plan, rather than a reactionary attempt to salvage a losing trade.
For stock investors, the scale-in strategy is buying additional stock as the price drops. An investor using this strategy assumes that the price decline is temporary and the stock will ultimately rebound, making the lower price a relative bargain. It’s one method (of many) of how to make a mean reversion strategy.
So, buying as the stock price drops becomes a planned trade entry strategy. In essence, the scale-in strategy is the process of gradually increasing a stock position until it reaches the number of shares or you have invested the dollar amount you planned to invest.
The scale-in strategy offers more flexibility in market timing and enables you to achieve the most optimal average price for their positions.
However, the process requires enormous discipline to stick to the plan when things seem to be falling apart because most of the time, you would be going against the grain and catching a falling knife — buying when the market is selling or selling when the market is buying.
To be successful with the scale-in strategy, you need to be totally convinced and not bother about the so-called wisdom of the masses, but you must be present enough to regularly assess your strategy based on your parameters and performance indices.
Dollar-cost averaging
There are different ways of implementing the scale-in strategy. One common one among investors in the stock market is dollar-cost-average, which involves buying shares as the price decreases.
In this case, you set a target price and then invest in volumes as the stock falls below that price. This buying continues until the price stops falling or when you have reached the intended position size. Scaling in, therefore, allows you to lower the average purchase price since you pay less each time the price drops.
Buying into selloffs often goes against the grain when trading momentum (any momentum strategy), and if the stock does not come back to the target price, you may end up with a losing position. But when it works and the stock price rebounds, scaling in is a great way to optimize pricing, minimize the downside, and maximize upside potential.
Scaling is especially useful when you want to buy a large number of shares, and the stock is not very liquid — that is, a stock with smaller daily trading volumes and a wide ask/bid spread. If you buy a huge volume at once, you would move the market by a lot and end up paying a higher price per share. With the scale-in strategy, you have a better average position price upon entry.
Scale-out
However, for such stocks, low liquidity can also be an issue when you want to sell your shares, as large sell orders can invite other sellers to step in front of your ask and push the price lower, offering you less amount for your shares. This is where scaling out comes in – the opposite of scaling out. Scaling out is to offset your position in smaller pieces so as not to impact market action.
Scale-in and different trading strategies
All we have discussed so far about purchasing as the price drops further may apply mostly to investors who have the patience to wait for the price to rebound.
For day traders, especially in the forex market but also in stocks, scaling in means a different thing entirely. Of course, as with investors, many traders use the scale-in strategy to increase their position sizes, but the way they do that differ.
Let’s look at how different type of traders might use a scale-in trading strategy:
Scale-in trading strategy for day traders
While the investors think of scaling in as a way to lower their average purchase price by buying as the price drops lower, day traders might consider scaling in as a way of testing the market’s disposition first and increasing their position size if the market is favorable so as to make more money.
In other words, a day trader who uses the scale-in strategy only adds to a winning position and hopes that the market would continue moving favorably.
Day traders’ method of scaling in is to test the market with a small trade size first and then add more trades if the market is moving favorably. This testing with a smaller size and loading up at a higher price may seem like a lack of trust in their trading approach. But to understand day traders’ idea of scaling in, you have to understand that, unlike investors who have the luxury of waiting for a stock to rise, day traders trade on a very short time frame and like to be profitable the moment they enter a trade.
With their method of scaling in, if their initial market timing is wrong, their losses won’t be much with smaller position size. That is why they test to see that the market is ready to move as they anticipated before adding more positions at higher prices, as the market continues to move in their favor. By adding to a winning position, they can use the floating profit from the already winning position to bear the risk of the new position.
However, no method is without its risks. Buying at higher prices or selling at lower prices comes with the risk of a sudden market reversal draining out the floating profits, and the trade ending in a loss if the trader is not careful. Even for a careful trader, a sudden reversal can result in a loss in the later positions and at most a lesser profit in the initial position.
Scale-in trading strategy for institutional traders
Another group with a different perspective on scaling in is institutional traders who often trade huge orders. Because of their huge order size, they have to enter their trades gradually until they load up their full position size. While they may not be overly concerned about getting in at lower prices like the retail investor who seeks dollar-cost averaging, they can push for lower prices in search of orders to fill their position. What matters to them is to fill their orders without attracting attention — they don’t want people to front-run their orders.
Big hedge funds, like Jim Simons’ Medallion Fund, use scale-in strategies all the time.
In summary, retail investors use the scale-in strategy to buy at different intervals as the price drops so as to lower the average price of purchase. Short-term traders use the scale-in strategy to add to a winning position so as to potentially increase their profit potential while using the already made floating profit to bear the risk of the added trades. Institutional traders, on the other hand, use the scale-in strategy to hide their activities to avoid front-running and huge price impact.
The difference between scale-in, double-down, and Martingale strategies
It is important we briefly state the difference between these three trading strategies. The scale-in strategy should not be mistaken with the double down strategy or Martingale strategies, which are actually desperate actions of trying to salvage a losing trade by adding more with the hope that a smaller move can help bring the overall trade to breakeven.
The key difference is that the scale-in strategy is a well-thought-out trade entry strategy whereby a trader gradually builds up their position for whatever reason, mostly to have a lower average entry price, while the double-down method is about adding another position to a losing position with the hope that a smaller favorable price move would bring the position to breakeven.
The Martingale strategy is a version of the double-down strategy where the next added trade is double the size of the already existing position. Both the basic double-down strategy and the more risky Martingale strategy are only about throwing good money after bad in an attempt to avoid taking a loss.
How do you scale in a swing trade? (example)
It depends on the strategy a swing trader is using. Swing trading is a form of short-term trading that last from a few days to a few weeks. So, it requires adequate market timing to get in at the right time and ride the next price wave. A swing trader may not have the luxury of time to wait for the market to reverse if it continues to drop, and as such, may not use a scale-in strategy with the aim of dollar-cost averaging.
However, a swing trader that uses a mean-reversion strategy may decide to divide their position sizes and add positions at different potential reversal levels, as the tendency of a mean-reversion move increases the further away the price is from its mean value.
On the other hand, swing traders who use a trend-following approach are more likely to use the scale-in method used by day traders — adding on a winning position to make more profits. For example, if a trader is purchased 100 shares at $20 and the stock rises to $25, the trader may add another $100 shares if they think the stock could rise to $30. If that happens, the trader ends up with a $1,500 profit instead of a $1,000 profit if they hadn’t added another position.
Scale in vs. scale out (example)
Scale in and scale out are two sides of the same coin. While you use the scale-in strategy to gradually build up your full position, you use the scale-out technique to gradually exit from your trades. Here is how the scale-out strategy works:
Assuming you have a total position of ten thousand shares of stock XYZ in the market and want to exit your trade gradually, you can use the scale-out strategy. You use this method when the trade has reached your initial profit target but seems like the market could continue to go in your direction. What you do is close a portion of your trades to take profit and leave others to continue riding the trend. This way, you take advantage of the trend and at the same time, lock in some profits.
The good thing about the scale-out strategy is that it captures a profit while leaving the door open for additional gains. Moreover, you can move your stop loss to break even or beyond for the rest of the position after taking profit from a portion of the position. This way, the remaining open position would be almost “risk-free.
Pros and cons of scale in (advantages and disadvantages)
There are many benefits of using the scale-in strategy. Some of them are that it lowers the average entry price for long-term investors who target dollar-cost averaging, and it prevents huge slippage and front-running for institutional traders. For short-term traders who use it to add to winning positions, it enables them to risk little at the beginning and amplify their gains on a trade that has already begun to look like a promising move. They start their trade with smaller trade sizes and only add to the trade when it’s winning.
Apart from the benefits, the scale-in strategy has some disadvantages, whichever way you apply it. For those who use it to lower the average entry price, there is a risk that they may not enter all their position before the market turns and accelerates, thereby leaving the trader with a suboptimal position size. For those who use the technique to add to winning positions, there is a risk that the market can reverse immediately after entering more trades, which can lead to an overall losing position.
Scale-in trading strategy backtest – Trading Rules
Let’s backtest a complete scale-in strategy with trading rules and specific settings. This is the trading rules and how we do it:
Trading Rules
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We start with showing the scale-in strategy backtest by investing 100% of the equity on the first trading signal. The equity curve looks like this (what is a good equity curve?):
The strategy performance metrics of our “naked” trading strategy are pretty good:
- The number of trades is 409
- The average gain per trade is 0.68%
- CAGR is 9.3% – slightly better than buy and hold (what is CAGR?)
- Time spent in the market is 20.1%
- The win rate is 75% (why you want a high win rate strategy)
- The profit factor is 2.2 (profit factor example)
- Max drawdown is 21% (how big max drawdown can you tolerate?)
- Two losing years: 2009 and 2018
Let’s go on to scale-in and see what happens. The equity curve looks like this:
The equity curve shows that our scale-in strategy backtest has a lower CAGR (because the equity drops from 1.4 million to 1.06), but in our opinion, the strategy improves – a lot.
Our scale-in strategy has the following statistics:
- The number of trades is 409 (Amibroker counts each scale-in trade as one)
- The average gain per trade is 1.06%
- CAGR is 8.3% – slightly lower than buy and hold’s 9.3%
- Time spent in the market is 14.5%
- The win rate is 83%
- The profit factor is 2.9
- Max drawdown is 17%
- Two losing years: 2001 and 2018
What is the best strategy – to scale-in or not?
That depends on the trader. However, we believe that the best metric is to look at how much (or little) time you spend in the market compared to the returns.
One way of measuring risk-adjusted return is to compare the time spent in the market and the returns. Obviously, the same return with less time spent in the market is preferable. So let’s look at this ratio:
- No scale-in: time in the market is 20.1%, and return is 9.3%, which equals 46.3% risk-adjusted return (8.3 divided by 0.201)
- Scale-in: time in the market is 14.5%, and return is 8.3%, which equals 57.2% risk-adjusted return (8.3 divided by 0.145)
Personally, we prefer the latter option (the scale-in strategy) simply because the capital is used more efficiently and could be employed elsewhere in the meantime.
If you want to learn how to backtest and don’t fall prey to random anecdotal “evidence”, we recommend our backtesting course that explains the essentials of backtesting, the same principles that we use daily on this blog and in our trading.
Scale-in trading strategy – ending remarks
There are many reasons as to why you’d might like to scale-in and this post have covered a few of the reasons. Many traders and investors are obsessed with picking tops and bottoms, but that is a futile exercise. Our backtest showed that you could improve your risk-adjusted return by scaling in, and thus this might be an alternative for many of your trading strategies.
FAQ:
How does the scale-in strategy work in trading?
In trading, scaling-in refers to gradually building up a position size as the market presents more entry opportunities. It’s a strategic approach to optimize the average entry price over time. The scale-in strategy involves adding to a trading position over time, either as the price drops (for long positions) or as the market shows favorable conditions. It’s part of a well-thought-out trading plan to achieve an optimal average entry price.
What is the purpose of the scale-in trading strategy?
The scale-in strategy aims to provide flexibility in market timing, enabling traders to achieve the most advantageous average price for their positions. It’s particularly useful for long-term investors practicing dollar-cost averaging and for short-term traders aiming to maximize profits.
How do traders scale in a swing trade?
The approach to scaling in a swing trade depends on the trader’s strategy. For mean-reversion strategies, traders may divide position sizes and add at different potential reversal levels. Trend-following swing traders may add to winning positions to maximize profits.