Question

1. Why is it a good idea to scale your position, and have larger positions when you believe there will be a large move in the index, and have smaller positions when you believe there will be a small move in the index?

2. A) What is the profit (or loss) generated on a position that is long 5 contracts @ 1050.00, if the price of the index falls to 975.00? B) If the dollar-margin requirement for index futures is 5% of the notional value, what is the beginning margin requirement for a single RTX future?

Answer 1

ANS.1.

Introduction

Stock prices never go straight down or straight up, which is why many traders use limit orders, or simply try to buy on down days and sell on up days. But picking the perfect entry and exit price for a stock you own or would like to own, is nearly impossible, often frustrating task. Inevitably, no matter how long you wait for the perfect entry price, as soon as your order is filled, the stock often seems to drop further in price. Likewise, after waiting for your position to reach what you think will be the perfect selling price, the price often seems to climb even higher after you sell.

Scaling of Position

Scale in is the process of purchasing shares as the price decreases. To scale in (or scaling in) means to set a target price and then invest in increments as the stock falls below that price. This buying continues until the price stops falling or the intended trade size is reached. Scaling in will, ideally, lower the average purchase price. If the stock does not come back to the target price, however, the investor ends up purchasing a losing stock.

A scale in strategy gives an investor the option of buying additional stock as the price drops. Profitable traders turn to scale into a position for a variety of reasons. Some of the more advanced thinking postulates it's a good idea in order to reduce the amount of slippage received when opening a large trade or to hide a large position that you don't want others to know about. The most important and common reason why traders scale into a trade is to amplify their gains on a trade that has already begun to look like a promising move.

When a trade moves in an investor's favor, larger trade sizes, of course, result in larger profits. However, when an investor can start off their trade with a smaller trade size and only add to a trade when it's winning, they are able to start off our trade by risking a little and end our trade with potential for a greater return. Not only does scaling in enhance the profit potential, but it also reduces risk by starting with a smaller trade, only adding to the trade after it's profitable.

Scaling out of the trade is a similar idea to scaling in but in reverse. Rather than closing out an entire position once a target price is reached, an investor will partially close the trade in increments, allowing the rest of the shares to ride the stock's move further into profitable territory. This strategy captures a profit while leaving the door open for additional gains. It is also common to move your stop loss to break even or beyond when an initial profit target is hit. That way the remaining position you have open is almost "risk-free."

Conclusion

It’s not really necessary to pick the exact top or the exact bottom to be a successful trader; but it will definitely help if you can get somewhere close. This is why I advocate scaling into and out of your positions, especially during times of higher market volatility. Keep in mind that using this strategy will increase your commission costs, potentially significantly, because you’ll be making more trades.

ANS. 2.

Calculation of profit or loss on long position

No. of Contracts = 5

Long position at = 1050

Current price of Index = 975

Hence,

            Loss = 5 X (1050 – 975)

                    = 5 x 75

                    = 375

Beginning Margin required = 5% of Notional value

                                                 = 5% of 1050

                                                 = 52.50