I was recently asked by a new trader about Scale Trading in the Forex Market.
I hope this inexperienced trader and I are talking about the same idea when we mention “scale trading.” In case you do not know what scale trading is (or at least how I define it), a link to an article I wrote about it can be found at the end of this article.
With scale trading, you buy an instrument when it is at historical or near historical lows, and sell it at slightly higher levels. The general idea is that there is a floor that the trading instrument will never go below.
For example, with sugar, chances are it will never go to 0 (zero) cents/lb, as people will always want and need it to some extent. But, what if sugar is suddenly linked with a life threatening disease, and all world governments ban it? It could get close to zero and stay there, if people decide never to eat sugar. Unlikely, yes, but still remotely possible.
So, back to the subject of forex and scale trading – is it a good idea? Let’s take the EURUSD pair. It is currently at 1.41078. Historically, it has been as low as 0.8227 (back in 2000). So right now, it is not a good candidate for scale trading, since you want to start scale trading at or near an historically low price. But if it was, would you feel safe buying on a scale down to.8227 or lower? I wouldn’t, because what if the Euro gets dissolved, and becomes worthless? You’d be buying a lot of Euros on the way down from.8227 to zero.
So, in my risk adverse (and somewhat simple) mind, I’d scale trade only in Forex if I was prepared for the pair price to collapse completely (ie price go to zero). Do you think a currency can never collapse? Well, I have a One Hundred Trillion Dollar (yes, that’s 100,000,000,000,000) bill from Zimbabwe, printed in 2008, I can show you. It proves currencies can and do collapse!
The same logic also holds with reverse scale trading in Forex. In our EURUSD example, if the USD went to zero, the pair would skyrocket. What is the upper limit in this pair? I have no idea, but I’d hate to develop a reverse scale based on an educated guess.
At its essence, scale trading is all about risk control. If you set up a scale in any tradable instrument, and you can ride it down to the bottom without quitting (either through margin calls or sheer frustration), IF and when the price picks up, you could fare pretty well.
In my mind, though, there are better ways to make a buck than by scale trading.
Here is a basic description of scale trading: http://bit.ly/9xXW37