The Allure of Scaling Out: A Common Exit Strategy
One exit strategy that many traders use is designed to avoid losses, but it directly contradicts the golden rule of trading: 'cut losses, let profits run.' The strategy involves entering the market with a relatively large position and then gradually liquidating it through various exit points. For example, a trader might buy 300 shares of a stock. They then sell 100 shares when the position is at breakeven, sell another 100 shares after earning a $500 profit, and leave the final 100 shares to capture a potentially large gain. Short-term traders use this approach very frequently. On an intuitive level, this strategy seems to make sense. It appears to 'insure' profits by locking in small gains along the way. The trader feels they are reducing risk and securing something positive from the trade. However, upon deeper reflection and careful study, this exit strategy is actually dangerous. It creates a situation where the trader holds the largest position when the trade is losing and the smallest position when the trade is winning. This is the exact opposite of what the golden rule prescribes. The strategy may provide psychological comfort, but it does not optimize profits. In fact, it can systematically produce large losses and relatively small profits. Understanding why this happens requires examining the mechanics of the golden rule and the mathematics of partial exits.
The Golden Rule of Trading: Cut Losses, Let Profits Run
The golden rule of trading—'cut losses, let profits run'—is a foundational principle in many trading methodologies, particularly trend following and momentum strategies. The logic is straightforward: when a trade moves against you, you should exit quickly to limit the loss. When a trade moves in your favor, you should stay in the position to allow the profit to grow. This rule ensures that your average winner is larger than your average loser, which is essential for a positive expectancy system. Implicit in this rule is a relationship between position size and being right or wrong. Ideally, you want your largest position size when the trade is working in your favor, and your smallest position size when the trade is not working. The golden rule naturally supports this: by cutting losses quickly, you keep the position small during adverse moves; by letting profits run, you keep the position large during favorable moves. In contrast, the scaling-out exit strategy described earlier does the opposite. It keeps a large position during the losing phase because the trader has not yet exited the full position. Then, as the trade becomes profitable, the trader reduces the position size by taking partial profits. This means the trader is carrying maximum exposure when the trade is wrong and minimum exposure when the trade is right. This inversion of the risk-reward profile is why the strategy is so harmful. It is not just suboptimal; it is a direct violation of the core principle that supports profitable trading over time.
