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Multiple Contract Scaling Exits: Is it Better?

March 28, 2005

 

With the immense popularity of the e-mini SP contract and the growing popularity of the e-mini Russell - it seems those interested in day trading systems have more choices than ever. One development gaining popularity recently, but not new by any means, is the use of scaling exits with multiple contracts. Some call this method of getting out taking partial profits.

In its simplest form, multiple contract scaling exits is merely buying several contracts at the entry, then getting out of a few contracts for a profit while letting the rest run. Depending on how many contracts you did at the entry and how many profit levels you reach, this could mean multiple profitable exits, each new exit more profitable than the previous one.

At first glance, the logic behind taking partial profits does make a lot of sense. Enter a trade with multiple e-mini contracts, scale out of them as the position becomes more profitable, and eliminate the possibility of the market turning around and stopping you out for a full loss on all three contracts. After all - taking three profits sounds better than taking just one.

It is also easy to see why scaling exit strategies have become so popular in the current tight trading ranges. Trading the stock indices is a difficult as it ever has been with continuously shrinking daily ranges and volatility readings. . For example, the e-mini Russell has only traded in a 53 point rage this entire year after posting a 143.50 point range in 2004. This is yet another indication of further consolidation and lower volatility in the US Stock market. The chart below shows an example where scaling exits allowed the system to exit out of 2/3rds of the contracts at a higher price than the eventual system exit. Not every chart will look like the one below, but it only takes a few trades like the one in this example to make sense in the tight trading ranges.

*The chart above was created with TradeStation. It is for illustration purposes only and does not represent trading in an actual account.

But while they give the impression of being sophisticated, the scaling exit strategies used in e-mini day trading are not very complicated at all, with most strategies simply using static profit levels as their exit points. For example, 2 points for the first profit target, 4 points for the second, and so on. They then let the final contract "ride" for the remainder of the market session. While this strategy can produce some very pretty charts (see above), whether or not it is as profitable for the investor is up for debate.

One of the reasons that the logic of a scaling exit strategy is in question lies in its alternate name - partial profits. It sure seems counterintuitive to take partial profits, but FULL losses. No one has developed a strategy that successfully scales out of losing trades yet, so what we're talking about is risking a full stop out in exchange for gains on only 1/2 to 2/3 of your profits.

Devil's advocates of the scaling exit strategy will argue that you will get nowhere fast when your average losing trade is greater than your average winning trade, and there's a lot of truth in that. For a partial profits strategy to be worthwhile, the system must win a great deal more than it loses - either with occasional HUGE winning trades on the final "let it run" contract or by way of a high winning percentage of 60% or more.

Imagine a system trading the emini S&P futures which risks 5 points on three contracts, then attempts to take profits on 1/3 of the position at 2 points of profit, 1/3 at 4 points profit, and the final third on a trailing stop. Assuming the trailing stop gets filled at an average of 5 points profit (about 50% of the average daily range of the S&P), this system would lose 15 points, or -$750 (5 pts * 3 lots * $50) on its losers, and make approximately 11 points, or +$550, on its winners.[(2 pts * 1 lot) + (4 pts * 1 lot) + (5 pts *1 lot)]. This system would have to make money on over 58% of its trades just to breakeven, and be right close to 62.5% of the time to reasonably cover costs. Most day trading systems we know are right only about 50%-55% of the time.

If you take the stance that the system doesn't need to be right a high percentage of time to justify the scaling exits, all it needs to do is hit some really big trades on its trailing stops - setting the winning percentage at 50%, the math tells us that the average win on the trailing stop would have to be 12 points in our example above. If 4 out of 5 winning trades on the trailing stop averaged 5 points, 1 out of 5 trades would have to be 40 points to arrive at an average gain of 12 points on the trailing stop. Anyone who can remember any day trading S&P system grabbing a 40 point profit, raise your hand.

Now, no system exists in a vacuum - so we must measure the viability of the scaling exit approach versus trading the same system without the scaling exits - and just using the trailing stop for all three contracts. You can quickly see in the table below that no matter whether the system shows 60% winners and a 5 pt average win on the trailing stop OR just 50% winners but 12 points average win on the trailing stop; not using the scaling exits is the more profitable approach.

* The dollar returns in the table above are for illustrative purposes only and do not represent trading in an actual account. Please read carefully the CFTC required disclaimer regarding hypothetical results below.

Using the scaling exits with the scenario 1 system (60% winners, 5 point avg on the trailing stop) resulted in gains of just $30 versus gains of 5 times that when trading the same exact system but NOT using the scaling exits. Likewise in the scenario 2 system, the scaling exit version produces profits 7 times less than the plain system using the trailing stop only.

We generated our own trading scenarios here and made them work out in such a way as to show that scaling exits aren't necessarily better, but that doesn't mean they can't be. We could easily dream up a scenario 3 system which wins 70% of the time, and shoots for 1 more point on each profit level, and gets one more point on the trailing stop. As you can see below, you can fool with the math both ways, and make the profit levels, average winning percentage, and average trailing stop work out in such a way that the scaling exit looks much better than using the trailing stop alone.

* The dollar returns in the table above are for illustrative purposes only and do not represent trading in an actual account. Please read carefully the CFTC required disclaimer regarding hypothetical results below.

However, the point remains that for scaling exits to make sense, you better make sure your system has a high winning percentage or happens upon some very big winners rather frequently. If not, you'll be taking a full loss on losing trades while only capturing a portion of profits (only making back some of the losses) on winning trades.

One last thing to remember is slippage. While you would be doing the same number of contracts whether trading straight 3 lots on a system or 3 lots with scaling exits, the trading fees associated with scaling exits will be higher than those without. How can this be? An investor's commission rate and exchange fees surely aren’t effected by position strategies. It is because of SLIPPAGE, that hidden trading fee.

While 1 tick of slippage on three lots on a single trade (1 trade * 1 tick * 3 lots = 3 ticks slippage) is equal to 1 tick of slippage on a single lot on three separate trades (3 trades * 1 tick/trade * 1 lot/trade = 3 ticks slippage), slippage only happens when you're getting into or out of the market - and getting in and out two extra times per day will equal more opportunities for slippage no matter how quick you are or what type of software you employ.

So before believing blindly in the power of scaling exits, check the system's winning percentages, profit levels, and average win on the trailing stop. You may just be better off trading it plain and simple.