Chapter 6: The World’s Worst Trading Strategy
The next step down our road to investment success involves briefly reviewing the worst stock trading strategy I can imagine, a simple strategy known as Scale Trading. Why would we want to learn about the worst strategy? Because once we know the worst possible strategy, one that is destined to maximize losses over the long run, then we can reverse its ideas to craft a strategy which does just the opposite – it will be destined to produce some tremendous long-term gains. This is precisely how I came to develop the Reverse Scale Strategy introduced in the next chapter, which has served me very well and will also serve you well if you adhere to it. I want you to not only know what the strategy is but also to understand how it was developed and why it works.
I want to mention that the comments in this chapter focus on scale trading as applied to stocks only. Scale trading can be a viable strategy when applied to commodity futures, mostly because commodities have inherent value meaning that they cannot decline to zero value. But even then, it requires a lot of capital and advance planning to be successful. Individual stocks can and do become worthless on occasion, which is one of the main reasons why scale trading is such an unfit approach for stock investing.
Scale Trading
Other than the fact that it is simple, this strategy has no redeeming value. It is the manifestation of all the most devastating investor mistakes. While it can produce small profits over short periods of time, eventually it always leads to the poorhouse when applied to individual stocks. Scale trading is not a very popular or widespread strategy except among extreme neophytes, as anyone using it will not last very long in the stock market. I like to think of it as the financial equivalent of bungee-jumping: It’s exciting, risky, takes a lot of guts, and occasionally, the cord snaps! Nevertheless it is useful to study this method because often much can be learned by studying a truly bad approach to anything and then reversing its concepts.
Scale trading can be applied to a single stock, or a portfolio of stocks with equally disastrous results.
It is accomplished by taking an inital position and then adding to it in predetermined increments as the position declines in value, and selling those purchases as they increase in value. For instance, the investor might buy 20 shares of stock at $50/share (for $1,000) and decide to buy another $1,000 worth of stock if the price declines by 20%. If the price increases from $50 before declining to $40, he will sell his 20 shares (purchased at $50) for $60/share, for a profit of $200 less commissions. So, another 25 shares are added at $40 with the idea of selling those acquired at $40 if the price then increases to $50, and so on. The purchase and sale levels for this particular situation are shown in the following table:
Scale Trade from 50, 20% declining purchase increments.
| Price Level | Amount Invested This Purchase | Shares bought This Purchase | Cumulative $ Invested | Cumulative Shares Owned | Cumulative Value of Shares | Cumulative Cost/Share | Total Profit/(loss) |
|---|---|---|---|---|---|---|---|
|
50 |
$1,000 |
20 |
$1,000 |
20 |
$1,000 |
$50.00 |
$0 |
|
40 |
$1,000 |
25 |
$2,000 |
45 |
$1,800 |
$44.44 |
($200) |
|
32 |
$992 |
31 |
$2,992 |
76 |
$2,432 |
$39.37 |
($560) |
|
25 5/8 |
$998 |
39 |
$3,990 |
115 |
$2,944 |
$34.70 |
($1,046) |
|
20 1/2 |
$1,004 |
49 |
$4,994 |
164 |
$3,359 |
$30.45 |
($1,635) |
|
16 3/8 |
$999 |
61 |
$5,993 |
225 |
$3,686 |
$26.64 |
($2,307) |
|
13 1/8 |
$996 |
76 |
$6,989 |
301 |
$3,945 |
$23.22 |
($3,044) |
|
10 1/2 |
$996 |
95 |
$7,986 |
396 |
$4,152 |
$20.17 |
($3,833) |
|
8 3/8 |
$998 |
119 |
$8,984 |
515 |
$4,320 |
$17.44 |
($4,664) |
|
6 3/4 |
$1,000 |
149 |
$9,984 |
664 |
$4,456 |
$15.04 |
($5,528) |
|
5 3/8 |
$999 |
186 |
$10,982 |
850 |
$4,563 |
$12.92 |
($6,419) |
|
4 1/4 |
$1,001 |
233 |
$11,983 |
1083 |
$4,651 |
$11.06 |
($7,332) |
The scale trader is hoping to profit by, for example, selling any shares acquired at 32 on a subsequent rise to 40, any shares purchased at 20 1/2 would be sold at 25 5/8, and so on until the stock advances to 60, at which point the scale trader sells off the last of his shares – those purchased at 50.
There is no limit to the amount of times that a stock can oscillate between any two or more of the price levels. Each time this happens the trader pockets another $200 profit, excluding the effect of commissions.
It seems like a foolproof approach to the neophyte trader, but let’s trace what happens with this trading method through a hypothetical situation. As indicated, our trader makes up the chart as shown above, and takes his position of 20 shares purchased at a price of $50/share. Let’s say the price then slips to $40, and a subsequent 25 shares are purchased at that price. From there, the price increases to $55, meaning that the 25 shares acquired at 40 are sold when the price reaches $50, netting a profit before commissions of $200. At this point, 20 shares acquired at $50 are still in his inventory. However, he doesn’t get to sell those shares, as the price drops from $55 all the way down to $30 – so 25 shares are purchased at $40, and another 31 shares at $32 before increasing again to $40. The shares purchased at $32 are sold for $40 for another $200 profit. Fantastic: He has so far generated a $400 realized profit and never had more than $3,000 invested at any point. The only negative so far is that it took four months to do this, but $400 profit on a $3,000 investment over four months is not bad. So far, so good.
From $40, the price then takes another dive down to $15. Shares are purchased at $32, $25 5/8, $20 1/2, and $16 3/8. Then the price runs up to $30 before retreating back to 25 5/8. Quite a windfall for our trader as he sells the shares acquired at $16 3/8 for $20 1/2, and the ones scooped up at $20 1/2 for $25 5/8. From this, he nets out another $400, bringing his total trading profits to $800. True, he has a $1,046 unrealized loss bringing his net profit to a negative $246, but he reasons that when the price goes back up to $60 he will have completed his trade and sold out every single position for a profit. At this time, though, he narrowly misses selling his shares acquired for $25 5/8 at 32, since the price topped out this time at $30.
Next, the unexpected happens. The company that our scale-trading friend is trading reports that it is under Federal investigation concerning false financial reporting. The next day, the stock opens a few points lower and just keeps on dropping until it hits $10 3/8, its closing price for the day. Though shaken by the news, our friend is disciplined about his system and buys slugs of the stock right on schedule at $25 5/8, $20 1/2, $16 3/8, $13 1/8, and $10 1/2. He is getting a little worried because he is eight months into this trade and he has an $800 realized gain and a $3,833 unrealized loss so far. He also is realizing that so far he has nothing to show for his nearly $8,000 investment except a net loss. He starts to wake up at night wondering what will happen to his position, since although he realized that this could happen, he never thought that it actually would happen.
Unfortunately for our friend, in the following months the investigation reveals that the company does actually have some fraudulent practices. This requires that the balance sheet and income statements for some previous years are revised to reflect the effects of the management mistatement and coverup. The experienced (though crooked) management of the company is ousted for their sins and replaced. So the price of the stock works its way lower and eventually levels out between $4 and $5 per share, and it languishes in the low single digits for the next five years. Our scale trading friend has a $6,000 to $7,000 unrealized loss in addition to his $800 trading gain, and ten or eleven thousand dollars invested in the stock he still holds. Once in a while over the next few years he may get a $200 trading gain as the stock bounces around, but these pale in relation to what he has invested and what he could have earned even from a passbook savings account. On top of this, he also has to live with the worry for the next five years that the stock will further decline, causing him to either give up his strategy completely or invest even more money. Now he realizes that so much time has passed that even if the stock rises back up to $60 someday, his annual rate of return for the amount invested will be miniscule.
It is scary to realize what can happen when you get caught up into a flawed strategy such as scale trading. This little story might sound extreme, but I assure you that every single day someone gets the bright idea to do exactly what our poor friend in the story did. Thinking they have discovered a money machine, they begin scale trading and the rest is simply a matter of time. The trader in the story was disciplined – he held to his system against all odds, but he still got mired into a terrible mess. The lesson to be learned is that to be successful, you not only have to be disciplined, but the theory on which your system or method is based must be correct as well. A bad theory well implemented still results in a loss.
Of course, not every scale trade results in a disaster, in fact most of them probably result in a profit sooner or later. But the potential for profit is small considering the time, worry, and capital invested. The typical pattern with scale trades is a series of small profits followed by one gigantic and inevitable loss.
Some folks even apply the scale trading technique to several different stocks at the same time. This does nothing but compress the amount of time it takes to lock on to a stock that just keeps declining and declining in value – it may even become totally worthless and enter bankruptcy proceedings. Or, almost as bad, it may decline from $50 all the way down to $10/share and sit there for a long time. Perhaps it will sit there for years or even decades while the poor trader sits trapped in his losing position earning little or nothing on his money. You can rest assured that anyone who uses this approach consistently in the stock market will meet this demise fairly early-on in the process. The fatal assumption made by the scale-trading theory is “what goes down must come up,” and as we have discussed earlier, this simply is not the case with stocks.
In the example above, if the price of the stock declines to slightly above $1/share, the hapless scale-trader will own stock with a market value of $4,900 in which he has $17,900 invested – a loss of $13,000. If the company goes bankrupt, the numbers would be worthless stock and at a sickening loss of at least $17,900 (if he had sense enough to stop buying once the stock fell below $1/share). This is after starting with only $1,000, and the usual case is that the neophyte feels his strategy is so foolproof that he starts with $5,000 or some other large amount. The only saving grace is that people tend to pursue this strategy when they are young, foolish, and have little money to lose. So if our novice scale trader started with a $10,000 initial position at $50/share instead of the $1,000 position in the example, he likely won’t lose the entire $170,900 we might expect him to lose. This is because unless he inherited his money, he probably won’t have that much to lose.
The positives of scale trading are:
- It is simple and not subjective.
- It can generate lots of small gains in choppy market conditions.
The negatives of scale trading are:
- When applied to a portfolio of stocks, the stocks which do worst suck up the most capital as more and more purchases are made while it declines. All capital is automatically allocated to the worst-performing stocks in the portfolio while the best stocks are sold off. The result is at best a disastrous underperformance versus the market or at the worst a total loss of capital. If a scale trader uses margin (borrows money from the broker to buy even more stock), the trader may, under the right conditions, creatively find a way to lose even more money than he has. The biggest problem is that scale trading cuts the trader’s gains and lets his losses run, just the opposite of what you want to do.
- It is impossible to plan how much capital it will take to execute the strategy since you never know how far down a stock will go before it recovers – if it does recover. There are an infinite number of 50% declines between any positive number and zero, therefore an infinite number of purchases you would need to make to fully execute the strategy. Few people I know have unlimited capital.
- Eventually, everyone who practices scale trading encounters a stock that declines precipitously and then goes bankrupt. The losses from such an occurance are huge. There have been a plethora of seemingly rock-solid companies over the years that have ended up in bankruptcy court.
- The scale trader never gets the full benefit of a favorable trend since he is always selling his winners and buying more of his losers.
- Even when a scale trade is successful, the amount of profit to be had is very small relative to the amount invested and especially relative to the risk of catastrophic loss.
- When a scale-trader finds himself locked into a large losing position, he can’t even get the tax benefit of a writeoff, since his strategy makes no provision for him to sell out his position. Of course, if a bankruptcy should occur, then he can write off the entire amount!
Obviously, scale trading is not a strategy to pursue unless you want to guarantee yourself substandard returns peppered with an occasional financial disaster. In the next chapter we will take this lemon of a method and make lemonade. By reversing the scale trader’s tactics, we will construct the Reverse Scale Strategy, which will give us some moderately large gains, some small losses, and some huge gains which will make it all worthwhile. Better yet, the rules of this strategy will be as forthright and unambiguous as in the scale trading method.
Five Minute Investing Course
Introduction
Chapter 1: Replacing Our Stock Market Myths
Chapter 2: Things to Avoid
Chapter 3: Know Yourself
Chapter 4: Stock Picking
Chapter 5: How to Evaluate a Trading Strategy
Chapter 6: The World’s Worst Trading Strategy
Chapter 7: The Reverse Scale Strategy
Chapter 8: Margin Power
Chapter 9: Implementing the Reverse Scale Strategy
Chapter 10: Getting Started