One of the biggest mistakes that traders make is assuming they have to be completely right from the very beginning.
First, you find a trade that you like. The fundamentals line up, the chart looks good, and suddenly there is that conviction to take on that position. After all, if you believe EUR/USD is going higher, why not just buy everything now?
Legendary currency trader, Bill Lipschutz, offers a rather different approach in going about executing a trade. And it is one that I myself have been using as part of my own trading approach for well over a decade now.
The name Bill Lipschutz might sound familiar to many, as he is one of the renowned names profiled by Jack Schwager in The New Market Wizards. If you’re new to trading and even if you’re not, that is a series of books I would recommend to read. Even after all these years, I still tend to revisit them every now and then myself.
Lipschutz is a strong advocate of scale trading, which essentially means building and reducing positions gradually rather than treating every trade as one giant all-or-nothing decision. That allows him to build into a larger position as the market moved his way.
The easiest way to understand the concept might be to forget currencies and stocks for a moment and imagine that you’re apple trader.
Let’s say you think that apple prices are going to rise because a poor harvest is reducing supply.
Apples currently trade at $1 each but you’re not certain that your timing is right. So instead of buying 1,000 apples immediately, you buy just 400 apples today.
A week later, prices rise to $1.05 and reports confirm that supply is tightening. Your original idea is starting to play out, so you buy another 300 apples.
A couple of days later, prices then rise to $1.10 and the shortage becomes even clearer. And so, you decide to add the final 300.
Yes, your later apples may have cost more. However, that’s precisely the point.
Essentially, what you were doing was deliberately accepting a slightly worse average entry price in exchange for greater confirmation that your trade thesis is correct.
If the price had instead fallen sharply after your first purchase because the harvest outlook improved, you would only have committed 400 apples’ worth of capital rather than the full 1,000 apples.
Scale trading is therefore not about getting the cheapest and best possible price. It’s about balancing price against certainty.
You give up the possibility of getting your entire position at the perfect price in exchange for reducing the risk of being fully committed to the wrong idea.
That is the basic thinking behind scaling in on a trade.
I must warn though that there is a distinctive difference between this and blindly buying more every time prices fall. Lipschutz’s philosophy was closer to the opposite of the latter.
Position size should be small enough that being slightly wrong on timing doesn’t knock you out of the trade, while larger exposure is earned as the market increasingly supports your thesis.
Now that we have grasped one side of the idea, let’s take a look at the other – scaling out on a trade.
Let’s again go back to the apple trader example above.
Apple prices have now risen from all the way up to $1.50 from when you first bought them. You still think prices could reach $1.70, but suddenly weather conditions improve and new supply is appearing.
Do you sell all 1,000 apples today?
You could. But if prices keep climbing, you have completely removed yourself from a winning position.
Instead, perhaps you sell 300 apples at $1.50. And so if prices rise further, you can still participate in that position.
But if conditions deteriorate instead, you sell another 300 apples. Eventually, as the original thesis weakens, you close the remainder.
And this instance is precisely where Lipschutz’s strategy shines more than many others. Scale trading means you may not achieve the theoretically perfect exit, but you also reduce the chance of getting the “worst” outcome in closing out your position.
It is this very approach that helped Lipschutz remain involved in long-running winning trades rather than trying to identify the exact top in those trades.
That for me, is the arguably the most valuable lesson here.
Scale trading isn’t about finding a smarter or more cunning entry technique. It is about accepting that markets are uncertain and our timing will rarely be perfect.
It’s about not just asking “what price should I buy?” or “what price should I sell?”.
It is about diving deeper and thinking of the dynamism in markets and how to play around that with your capital. The better questions to ask may be “how much conviction do I have now in this trade?”, or “what would increase or weaken that conviction?”, or perhaps “how much capital should I have exposed at this stage of the trade?”.
Naturally, there are some tradeoffs with this approach. For one, it requires clear position-sizing rules for the most part. And also, it can turn into a slippery slope if traders use it as an excuse to endlessly add to losers.
But if used properly, the philosophy is refreshingly simple.
You don’t need to prove that you’re a genius by catching the exact bottom and selling the exact top. Sometimes the smartest way to trade bigger is to begin smaller.
This article was written by Justin Low at investinglive.com.