Volatility scale-in system

By Volker Knapp
Market: Stocks.

System concept: The October 2009 Active Trader article “Scaling in as an entry technique” by Howard Bandy reviewed a number of progressive/partial trade-entry techniques. Scaling into positions consists of entering trades in steps as price decreases or increases. Ideally, scaling in should reduce the average buying price (or increase the average short-sale price). However, as Bandy noted, although the approach can reduce risk, this benefit is not always worth the reward.

This system uses one of the scale-entry techniques from that article — the “reverse pyramid” technique, or “averaging up,” as Perry Kaufman referred to it in his book Trading Systems & Methods. Unlike averaging down (buying at progressively lower levels as price drops), whereby the system can end up “sitting” through a massive paper loss before a trade moves into the black, averaging up consists of adding to a winning position when price is moving in a profitable direction — i.e., buying at progressively higher prices for long trades and selling at progressively lower prices for short trades.

In Bandy’s test, adding to a position after either a 5- or 10-percent profitable move failed to outperform simply putting on a full position at the initial entry signal. Percentage- and point-based measures, however, aren’t universal — that is, they’re difficult to apply to different markets without optimization.

By contrast, basing a scaling increment on a volatility measure, such as average true range (ATR), is more robust than a fixed-percentage measure because it adapts to market conditions. (Among other things, volatility in downtrends can be quite different from volatility in uptrends.) The distance to the next entry level automatically adjusts as the market’s range shrinks or expands — something fixed percentages and points don’t do. Accordingly, the volatility scale-in technique we will test adds to a position when price advances by a certain multiple of the 10-day ATR.

A classic moving average crossover system will provide the framework for testing this scale-in approach. The system is a long-only trend-following strategy that establishes a small initial position and then adds to the trade as the market moves favorably. To prevent it from tying up too much capital in one stock, the number of entries in a single stock is capped at four.


For the complete article, see the April 2010 issue of Active Trader magazine. Click here to subscribe.



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