Pyramid Your Way to Profits

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Pyramid Your Way to Profits

Pyramiding is the practice of adding to lucrative positions in order to capitalize on a performing instrument. As the position expands, it provides for significant gains. Best of all, if done correctly, it does not have to raise risk. We will look at pyramiding trades in long positions in this post, but the same techniques may be used to short selling as well.

Misconceptions About Pyramiding

Pyramiding is not the same as “averaging down,” which refers to a method in which a losing position is added to at a lower price than the initial purchase price, thus decreasing the average entry price of the position. Pyramiding is the process of adding to a position in order to take full benefit of high-performing assets and so maximize profits. Averaging down is a considerably riskier technique since the asset has previously shown weakness rather than strength.

Pyramiding, from the standpoint of a trader, actually minimizes risk. This is because the principles of pyramiding require traders to begin with a single modest position and to designate a dedicated stop price. More size is added to that place if and only if it performs effectively. If the transaction performs badly after the extra size is introduced, the early profits might offset any losses. However, if the deal works well, the added size significantly enhances the profits. As a result, the strategy keeps the initial risk modest while offering massive profit chances.

Why It Works

Pyramiding works because a trader will only add to profitable positions that are exhibiting signs of ongoing strength. These signs may persist when the stock makes new highs or fails to return to past lows. Essentially, we are taking advantage of trends by increasing the size of our position with each wave of that trend.

Pyramiding is also advantageous in that risk (in terms of maximum loss) is not increased by adding to an already profitable position. Original and preceding additions will all be profitable before a new addition is made, so any possible losses on newer positions are compensated by earlier entries.

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Furthermore, when a trader begins to use pyramiding, the problem of taking gains too quickly is considerably reduced. Rather of withdrawing at the first indication of a possible reversal, the trader is required to be more analytical and wait to determine whether the reversal is just a halt in momentum or a true change in trend. This also provides the trader with the information that they do not have to make just one transaction on a given chance, but may instead make numerous deals on a single move.

Instead of executing a deal for 1,000 shares all at once, a trader might “feel out the market” by making the initial trade of 500 shares and then subsequent trades when it displays a profit. The trader may wind up with a greater position than the 1,000 shares they traded in one shot through pyramiding, since three or four entries might result in a holding of 1,500 shares or more. Because the initial position is smaller, the original risk is not increased, and additions are only made if each preceding addition is profitable. Let’s take a look at an example of how this works and why it’s preferable to just selecting one position and riding it out.

Real-World Application

For the sake of simplicity, let us assume we are trading stocks and have a $30,000 trading account limit. We aim to risk no more than 1-2% of our account on a single deal. We are only willing to risk $300 if we use a 1% maximum stop. A stop loss will be placed on the trade to ensure that no more than this amount is lost. We examine the chart of the stock we are trading and determine the location of a previous support level. Our stopping point will be right below here. If the current price is 50 cents below the previous support level and we add a tiny buffer (say, 55 cents), we can buy 545 shares ($300/$0.55=545). Round this amount down to 500 shares, and our risk is now less than $300.

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We could purchase 500 stocks and hold them for a long time, selling them anytime we like, or we could acquire a smaller stake, say 300 shares, and add to it as it profits. If the stock continues to trend, we will end up with a bigger stake (and hence greater profit) than 500 shares, and if the price falls, we will only lose money on 300 shares – a loss of just $165 ($0.55*300) vs $275 ($0.55*500) if we simply bought a static 500 share position.

Let’s look at an example utilizing a 15-minute chart of the British pound vs the Japanese yen (GBP/JPY). The circles represent entry, and the lines represent the prices at which our stop levels shift after each succeeding wave upward.

November 4, 2008. Image by Sabrina Jiang © Investopedia2020

In this situation, we will use a straightforward technique of entering on new highs. After a fresh entry, our stops will be moved up to the latest swing low. When a stop price is reached, all positions are closed. Our entry points are 155.50, 156.90, 158.10, and 159.20, as we build to our position with each subsequent climb to new highs after a reversal. The most recent reversal low provides us a first stop of 154.15, followed by 155.50, 157.00, and 157.50. Finally, the market reverses and fails to hit its previous highs. As this low gives way to a lower price, we execute our stop-loss order at 160.20, liquidating our whole investment.

The Verdict

Assume we can buy five lots of the currency pair at the initial price and keep them until the exit, or we can buy three lots at the start and add two lots at each of the chart’s levels. The buy-and-hold strategy yields a total gain of 2,350 pips (5 x 470 pips). The pyramiding approach generates a profit of (3 x 470) + (2 x 330) + (2 x 210) + (2 x 100) = 2,690 pips. This is an almost 15% increase in earnings without increasing the initial risk. This may be enhanced further by taking a bigger initial position or increasing the size of the subsequent positions.

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Problems With Pyramiding

Pyramiding may cause issues in markets that have a propensity to “gap” in price from one day to the next. Gaps may easily lead stops to be blown, exposing the trader to further risk by adding to positions at higher and higher prices. A wide gap might result in a significant loss.

Another risk is if the price changes between the entries are particularly big; this may lead the position to become “top heavy,” which means that possible losses on the newest additions might wipe out any gains (and perhaps more) generated by the prior entries.

The Bottom Line

It is critical to note that the pyramiding approach works well in trending markets and will result in more earnings without raising the initial risk. Stops must be regularly adjusted up to recent support levels to avoid greater danger. Avoid markets with significant price gaps, and always verify that extra positions and stops guarantee you will still earn a profit if the market reverses. This entails being aware of how far apart your entries are and being able to limit the danger of paying a much higher price for the new position.

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