In the Chatter area, I was asked by a C2 member to give my thoughts about Scale Trading in the Forex Market.
I hope this C2 member and I are talking about the same idea when we mention “scale trading.” In case you do not know what scale trading is (or at least how I define it), here is a link to an article I wrote about it: http://bit.ly/6xyhb6
With scale trading, you buy an instrument when it is at historical or near historical lows, and sell it at slightly higher levels. The general idea is that there is a floor that an instrument will never go below.
For example, with sugar, chances are it will never go to 0 cents/lb, as people will always want and need it to some extent. But, what if sugar is suddenly linked with a life threatening disease, and all world governments ban it? It could get close to zero and stay there…
So, back to the subject of forex and scale trading - is it a good idea? Let’s take the EURUSD pair. It is currently at 1.41078. Historically, it has been as low as 0.8227 (back in 2000). So right now, it is not a good candidate for scale trading, since you want to start scale trading at an historically low price. But if it was, would you feel safe buying on a scale down to .8227 or lower? I wouldn’t, because what if the Euro gets dissolved, and becomes worthless? You’d be buying a lot on the way down from .8227 to zero.
So, in my risk adverse (and somewhat simple) mind, I’d scale trade only in Forex if I was prepared for the pair price to collapse completely (ie price go to zero). Do you think a currency can never collapse? Well, I got a One Hundred Trillion Dollar bill from Zimbabwe I can show you that shows currencies can and do collapse!
The same logic also holds with reverse scale trading in Forex. In our EURUSD example, if the USD went to zero, the pair would skyrocket. What is the upper limit in this pair? I’d hate to develop a reverse scale based on an educated guess.
At its essence, scale trading is all about risk control. If you set up a scale in any instrument, and you can ride it down to the bottom without quitting (either through margin calls or sheer frustration), IF and when the price picks up, you could fare pretty well.
In my mind, though, there are better ways to make a buck than by scale trading.
Comments and criticisms are certainly appreciated.
Kevin
I heartily agree with you. Scale trading originated with Commodity Futures (metals, grains, softs, etc.). It was NOT intended for forex, but for things that supposedly had some residual value. You buy them at longterm lows and hold them as long as needed. And you can make "oscillation profits" in the meantime.
There was a book something to the effect "You cannot Lose money trading" But of course, you CAN.
And of course with futures, it gets very expensive because they have a longterm downward drift in prices due to carrying costs, etc. Now if for some reason one could be short longterm… Of course on the other hand, inflation tends to push things up longterm.
Still, it is a concept, not a money-making guarantee, especially for those of low funding.
The book is “You Can’t Lose Trading Commodities” by Robert Weist. You can buy it on Amazon.com (used) for $1.79.
My copy cost me well into five figures. Yes, I tried scale trading in Wheat in 1998 - Wheat was at its lowest point in years. I thought it couldn’t go lower. But it could, bottoming, I believe, in 2006. I would have probably made all my money back in 2008 runup, but I was long since margined out…
It is a pretty good book, though, if you want to learn the concept. You just have to ignore the misleading title, and the many references to 90%+ winning percentages…
This strategy represents 2 important fallacies and an extreme example of the latter:
1. St Petersburg Paradox (similar to martingale) – a strategy that assumes unlimited money.
http://en.wikipedia.org/wiki/St._Petersburg_paradox
2. Gap concept. The gap concept is an investment fallacy that focuses only on the end point but not on what can happen in-between. It was described in a paper by D.E Shaw. The gap concept has caused a lot of people to lose money. Even Buffet could fall prey to this, right he makes a trade that at the end point is a high probability but between here and there – that trade cost, I believe, a credit downgrade. The gap concept is something I’m always aware of even in short term trading because it dictates the tactics to use.
In a same vane, I would be willing to risk a significant loss on an account if I were guaranteed, legitimately, that the account would not lose any money if I held until a reasonable given future date (say 5 years) and there was a high probability I would get a sufficient (high) return for the risk. And, if this were possible then it might change my ideas on trading. But I do not believe that it is in the sense I’ve outlined.
âThe key to every successful scale trade is advance selection of a proper scale. If the numbers are worked out in advance and planned so all possible contingencies may be met without hazard to the capital in the account, it is impossible to lose. For example, if the person with $10,000 to invest buys his first MidAmerica contract of corn at $2.50 and plans to buy another contract each $1.00 down, he will have acquired contracts at $2.50, $1.50 and $0.50 if corn goes to $0.01. His paper losses would be $2,490 on the first contract, $1,490 on the second, and $490 on the third. Thatâs an aggregate loss of $4,470. This person would still have $5,530 of his capital intact. All he has to do is hold these contracts until they recover in price so he may sell them profitably.â
This was an example from the book to show how scale trading could be done with a limited account and to demonstrate if done properly it is impossible to lose in the long run. Choosing when to get in can be calculated based on past prices and size of account.
The greed in most of us will deviate from this example resulting in a good financial tail whoopin at some point.
As for scale trading with forex, all I could say is "scary."
