Have you ever abandoned a strategy because it had untolerable drawdown?
When examining the potential profit additions and potential loss reductions with scaling, the possibilities are quite significant.
The following comes with some assumptions.
Assumption 1: Your profit targets and your loss limits are numerically large enough in size in order to justify scaling. For discretionary traders, this number will be much higher, because the burden of computation and execution becomes untenable for fast moving markets and small increments. For automated traders, as long as the increments are large enough to support the resoluation/granularity, then scaling may be beneficial. (i.e. it wouldn't do much good to scale out or in if your strategy has P/L on the order of 2 ticks, but the effects will become much more prolific and relevant if you have P/L on the order of 10, 50, 100 ticks, etc).
Assumption 2: Your strategy isn't perfect. If your strategy/system has a perfect profit curve, then scaling will not add any value. Obviously, there's no one that features such a strategy, so a healthy dose of reality shows us that as consistent and close to the mean as we'd like to be (with wins and losses, expectancy, etc), everyone's system features a degree of variance away from the mean. The greater the variance, the more scaling will add in your money management.
Assumption 3: You have enough capital to feature scaling money management. For a simple 1 lot/1 contract strategy, obviously you cannot scale. For a 2 lot/2 contract strategy, you have the option of scaling in or out (one but not the other). For a 3 lot/3 contract strategy, you have the option of both scaling in and out.
Here's how it works.
Similar to MFE/MAE, runup and drawdown analysis will show you that there are a number of trades where the outcome fixes itself. That is to say, at a certain amount of runup, the probability that the trade will result in a profit increases. As the drawdown increases, at some point, it becomes very unlikely that your trade will recover.
Again, this depends on the level of variation away from the mean. The reason we carry the increment of stop loss that we do, is because we've determined that level gives us the optimum chance of surviving drawdown, but not cutting a winner short. A small percentage of our wins, will be at or near our stop. A greater portion of our wins will experience some drawdown, but more toward the average drawdown. A small portion of our wins, will experience very little to no drawdown. Conversely, a small percentage of our losses, will experience no runup whatsoever (hopefully, if we've developed an edge, the number of these types of losses will be significantly less than the no drawdown wins we achieve). A small number of losses will approach very close to our profit target (but retrace). The majority of our losses will occur within a standard deviation of the average/mean runup.
Scaling out. Scaling out provides more impact that scaling in for a couple of 2nd order/indirect reasons.
The first reason is that by scaling out of trades that are most likely destined to end negative, is that we reduce drawdowns (if nothing else, this is beneficial by itself alone). Reducing drawdown enables us to put more of our captial to work and requires us to carry less drawdown reserve. Carrying less reserve means that we can compound quicker. Not to digress, but a strategy that features half the profit (but half the drawdown) of a strategy that features twice as much of each, will outperform the latter strategy. Why? Compounding and increasing positionsize will quickly overcome the other strategy that must carry a larger amount of capital in reserve.
The obvious impact of scaling out is also reduction of total loss. Scaling out will reduce your average loss value, thereby making your strategy more profitable.
Scaling in. Scaling in can be beneficial to a strategy, however, I find that in MOST cases, if your strategy doesn't feature a great number of outliers, or a large variance …