Friday, July 22, 2005

Michael Taylor on scaling into trades

Michael Taylor makes the case that scaling into trades is usually less than optimal. I've been doing a lot of scaling into trades lately, so Michael's advice is very timely for me. I think part of the reason why I was doing so much scaled buying a few weeks ago is because I looked at the indexes, GOOG, and the housing stocks and I knew they weren't ready to come down at that time. Anyway, I've got to reconsider whether or not I could do better than scaling.

In volatility-based position sizing, the more volatile the issue, the smaller you want your position to be. The amount of capital you risk on a trade is based on the historic volatility of the issue. I've been illustrating 3 buy-points on the triple-cup base in many charts lately. Part of the reason I like using 3 buy points is that I see it as an alternative form of volatility based-position sizing. Rather than basing position size solely on the historic price volatility, the 3 buy-points base position size on the stock's potential drawdown while still remaining healthy at any given point in time during an advance.

The first buy point on the triple-cup base charts I've recently posted, I'm actually trying to pick a bottom. For this reason, I feel it is appropriate to have a smaller position because I need to be able to withstand some price volatility to find out if I'm right about the bottom or not. New lows and I'm gone.

The second buy-point is the break-out buy. This buy-point is usually where the most volatility occurs, so I don't think it's the best idea to put your whole position on at this point or you may get thrown out of what would otherwise be a good trade because you had too much capital at risk.

The third buy-point is actually right above my stop under a supporting MA. The shares in the third buy risk the least amount of capital loss, but also have the least potential reward. Because the entire position is at its lowest risk at this third buy-point, I feel it is best to have the position be at its maximum size.

So I guess I sort of felt like the 3 buy-points enforce a dynamic version of the volatility-based position sizing technique based on the risk of the position at any given point. In time I'll know if I can do better, but it really helps to have people like Michael casting a critical eye on things that deserve scrutiny.


At 11:25 AM, Blogger Mike Taylor said...

I've thought a bit about your contention that the 3 buy points are a dynamic volatility-based position sizing method.

Experience tells me these 3 buy points are really 3 seperate systems. Each should be trade with separate position sizing methods and exit rules. The great thing is you've already adjusted your position sizing on these 3 different systems based upon the risk factor associated with each as you've explained in your post. That's good.

Why not complete the systems by testing whether or not each entry would be better served by a different exit. Of course, it wouldn't hurt if you tested whether you're logic is indeed true on the position sizing method you are using for each entry.

And then back to the entries to test and determine whether you do truly have 3 valid systems on your hands. You might find one or two might not be worth your time or better yet used as filters to just one system.

You could spend weeks testing all the little complexities in this edge of yours. And in the end, I'm sure you would come away with a better understanding of the edge you are trading and quite possibly a bigger more defined edge than the original.



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