Why smart traders scale into positions, per Bill Lipschutz

A common error among traders is the belief that they must be entirely correct right from the start.

After finding a trade that appeals, with fundamentals aligning and the chart appearing favorable, conviction builds to enter that position. If one expects EUR/USD to rise, buying everything at once seems logical.

Bill Lipschutz, a famed currency trader, advocates a markedly different execution method. I have incorporated this approach into my own trading for more than ten years.

Many will recognize Bill Lipschutz as one of the legendary traders featured by Jack Schwager in The New Market Wizards. Whether new to trading or experienced, I recommend that series of books. I still revisit them frequently even after many years.

Lipschutz strongly endorses scale trading — gradually building and reducing positions instead of viewing each trade as a single all-or-nothing bet. This method lets him increase position size as the market moves in his favor.

To grasp the concept easily, set aside currencies and stocks and picture yourself as an apple trader.

Suppose you expect apple prices to increase due to a poor harvest constricting supply.

Apples currently cost $1 each, but you lack certainty about your timing. Rather than buying 1,000 apples right away, you purchase only 400 today.

A week later, the price climbs to $1.05 and reports confirm tightening supply. Your initial thesis is materializing, so you acquire another 300 apples.

After a few days, prices advance to $1.10 and the shortage becomes more evident. You then add the remaining 300 apples.

The later apples cost more, but that is exactly the intention.

In essence, you were willingly accepting a marginally worse average entry price in return for stronger confirmation that your trade thesis is valid.

Had prices dropped sharply after your initial purchase due to an improved harvest outlook, you would have risked only 400 apples' worth of capital instead of 1,000.

Scale trading is thus not about achieving the most favorable price possible. It concerns balancing price against certainty.

You relinquish the chance to enter the full position at an ideal price in exchange for lowering the risk of being fully committed to an incorrect idea.

That is the fundamental reasoning behind scaling into a trade.

I caution that this differs distinctly from blindly buying more on every price decline. Lipschutz's philosophy was nearly the opposite of that approach.

Position size ought to be small enough that a slight timing error does not exit the trade, while greater exposure is earned as the market progressively backs your thesis.

Having covered scaling in, let us now examine the other side: scaling out of a trade.

Return again to the apple trader example.

Apple prices have now climbed from $1 to $1.50 since your initial purchases. You still anticipate they might reach $1.70, but weather conditions have improved and new supply is emerging.

Should you sell all 1,000 apples today?

That is an option. But if prices continue rising, you would exit a winning position entirely.

Alternatively, you might sell 300 apples at $1.50. If prices climb further, you remain involved in the position.

Conversely, if conditions worsen, you sell another 300 apples. Eventually, as the original thesis unravels, you close the remaining position.

This scenario particularly highlights Lipschutz's strategy's advantage over many others. Scale trading may not yield the theoretically ideal exit, but it reduces the likelihood of achieving the "worst" outcome when closing a trade.

This exact approach enabled Lipschutz to stay in long-running profitable trades instead of trying to pinpoint their exact peaks.

In my view, that is arguably the most valuable lesson in this discussion.

Scale trading is not about discovering a cleverer entry technique. It involves acknowledging that markets are uncertain and our timing will seldom be flawless.

It goes beyond merely asking "what price to buy?" or "what price to sell?"

It means delving deeper and considering market dynamism and how to navigate it with capital. Better questions might include: "How much conviction do I currently have in this trade?" "What would strengthen or weaken that conviction?" "How much capital should I have exposed at this stage?"

Naturally, this approach involves tradeoffs. It largely demands clear position-sizing rules. Additionally, it can become a slippery slope if traders use it as a justification to keep adding to losing positions.

However, when applied correctly, the philosophy is refreshingly straightforward.

There is no need to prove genius by capturing the exact bottom and top. At times, the cleverest way to trade larger is to start smaller.