Pyramiding - Trading System

Pyramid into positions by Louise . Bedford

How do you decide when to pyramid your position? How much capital should I pyramid with? Pyramiding means adding equity to a position that is already trending in the expected direction and the method of pyramiding the same for trading short as for trading long

Once we have a position in play that has enabled us to move our stop from an initial stop to a breakeven stop and finally to a trailing stop we are faced with the issue of whether to add additional capital to a position.

You should never throw good money after bad by buying more of a share that is not trending according to your initial expectations. This is called 'averaging down'. By deciding to ignore your stop, and buy more of a down trending share, your average purchase price may be lower, but the amount of capital that you have in the trade would have increased. Following this strategy, you may be ultimately holding a large parcel of downtrending shares that are draining your trading equity. Often people follow this course of action in the doomed attempt to turn a losing trade into a winning one.

When to Pyramid

If you have moved your stop up to break even, and the share has continued to trend in the direction you were expecting, you could add money to your winning position. The way to do this is to set 'land-marks' which will help determine when this action is appropriate.

If you set your initial stop based on patterns, you could move your stops, or decide to pyramid based on an appropriate pattern appearing. If your initial stop was made due to a trigger by a specific indicator, if you get another signal from this indicator you could decide to move your stops, or pyramid.

Using ATR (Average True Range) to pyramid

Let's say that you're already in a position, and you have chosen a 3 Average True Range exit from your entry as an initial stop, and the share trends in the expected direction. When the share has gone up 6 ATR from your initial stop, (ie 3 ATR from your initial entry) you could move your stop to breakeven. (ie the stop is still 3 ATR below the current share price action).

When the share has gone up an additional 3 ATR from where you had decided to move your stop to the breakeven point, you could consider adding more money to the position (i.e. 6 ATR from your initial point of entry, or 9 ATR from your initial stop).

So, when the share moves up 6 ATR from your entry, consider pyramiding your position, and move your stop to 3 ATR below the current share price. When the share moves up 9 ATR from your initial entry, add another pyramid tranche and remember to move your stop to 3 ATR below the current price.

Every time you pyramid, you should re-set your stop based on the most recent ATR calculation, at 3 ATR below your new entry point. This ensures that the stops act as a mechanical ratchet to protect capital.

Your stops for every position should move in tandem, so you will not end up with a series of different stops for each pyramid point. You will get a chance to practice this skill, as it is essential to conquer in order to ride a trend effectively. As a suggestion, use a 15 - 20 day ATR.

If you are more used to using 2 ATR as a stop, the principles described above stay the same, but use 2 ATR increments instead of 3 ATR.

Pyramid Position Sizes

The additional input of capital into a trade should occur with smaller increments of the initial amount. For example, if you position sized based on 1% risk, your subsequent pyramid amounts could be based on .5% risk and .25% risk.

As the name suggest pyramiding involves the addition of sequentially smaller amounts of capital to any given position. Note the situation for pyramiding into futures is distinctly different to pyramiding into shares because a futures contract only requires the addition of a small amount of capital. Effectively the position is margined to around 98% of its total value.

With pyramiding into shares we effectively run into a efficient threshold beyond which it is prudent to add more capital. According to various theorems this frontier lies between 20% to 25% of capital. I regard that as too high and prefer the limit to be around 15%.

To examine pyramiding consider the following hypothetical

Let's assume we are trading a futures contract or any other highly liquid instrument.

If I buy 1 contract/share @ 100 with an Average True Range of 10, a 2 ATR stop puts me at 80.

The contract/share moves up to 120 and my stop moves to breakeven, the move to 120 is a pyramid signal so I reenter and buy an additional contract @ 120 the stop for this contract is 100.

So I have 2 contracts 1 bought @100 and 1 @ 120 both have their stop at 100. The contract/share moves to 140 and I move the trailing stop on the first position to 120 and the breakeven stop on the second position to 120. Using an ATR variable to move from initial to breakeven to trailing in set intervals allows pyramiding to occur.

As can be seen the pyramiding occurs at set intervals and the stop move according to those intervals.

If we were pyramiding into a share we would committ a smaller amount of capital into each move, so we may risk 2% on the first signal, 1.0% on the second and 0.5% on the third.

To see how this works lets consider the current example of NRT.

Assume that our system gave an entry signal on 17/12 @ $2.18, we have 50k to trade and the ATR on that day was 0.139 or 14 cents.

The first position is $1000 or 2% risk / 2 x 14 = 3,571 shares @ $2.18 or $7,748.74 committed to this position.

Our initial stop is $2.18 - $0.28.

Our pyramid point is entry + 2 ATR or $2.18 + $0.28 = $2.46.

The stock passes this point on 24/12 and we pyramid in committing an additional 1% to the position so we buy:

500/0.28 = 1,785 shares @ $2.46 = $4,391.10.

The stop on the first position moves to breakeven @ $2.18 and the intital stop for this new position is also at $2.18.

The introduction of guaranteed stops has altered the way traders can approach elements such as pyramiding an in turn the notion of pushing though any prudent capital allocation models. If will defer discussion of this until we have had a look at the theory of pyramiding.

The content of this site is copyright 2016 Financial Spread Betting Ltd. Please contact us if you wish to reproduce any of it.