Scaling Into Trades for Profit: Pyramiding Up
Scaling into positions is something that many traders do the opposite of, to their detriment. Certainly, it is a known technique, but how many apply it when they are spread betting their favourite financial instrument?
Pyramiding is a term used to describe the adding of more shares or contracts to your existing profitable position. As a stock rises in price, progressively smaller parcels are bought at higher prices until the desired position size is achieved. When done correctly, pyramiding is a highly effective way to increase your profits in a trade. It is what made Nicolas Darvas so successful and is the foundation of the Darvas method.
“Pyramiding instructions appear on dollar bills. Add smaller and smaller amounts on the way up. Keep your eye open at the top.” – Ed Seykota, Market Wizards.
Pyramiding into Positions
Pyramiding is a technique that many traders use when they want to trade on a strong trend. It has the advantage that it does not increase your risk while allowing you to take a larger position in a winning trade. It involves incrementally placing trades in the security, which allows you to remove the risk on previous trades before taking out new ones.
You will be aware that controlling your risk is one key element of being a successful trader. Some people say that you should not risk losing more than 2% of your total value on one trade, and others put the figure at 1%.
The way it works is this. When you have found a security that is trending strongly, and appears to be worth a trade, you make your trade in it in the usual way. You have to figure out your stoploss position, should the trend to turn around, calculate what this means in terms of monetary loss, and size your trade appropriately to keep within your adopted bounds of, say, 1%.
Obviously, if the trade does not turn out then it is closed on the stop loss, and you accept the loss in the usual way. You are no worse off than if you had never heard of pyramiding. On the other hand, it may work out, with the price going up assuming it is a long trade.
At some point, you will be able to raise your stop loss to your entry level, thus effectively eliminating any possible risk of loss on this trade. If and when this happens, you can consider placing another trade on the security, assuming it still looks as though it is trending strongly in your direction.
It is important to wait until there is no risk of loss on the original trade before you extend your position. You can make another trade, and the new stop loss position will be the same as now on the original trade. Now you have maybe twice the amount of funds in play, benefiting from the uptrend, yet you have never been in a position where you would lose more than your planned amount of 1%.
It is easy to see that you can continue doing this process, waiting until the latest trade has moved sufficiently that you can adjust the stoploss to a breakeven level. In fact, when you place your third trade you will be locking in a profit on the initial trade, as the stoploss level will be higher than the first breakeven level.
It is important that you adhere to the rule that the latest trade moves into profit with a breakeven stop loss before placing your next trade. You should also check that the trend is continuing strongly, and not showing signs of weakening.
Different traders adopt different rules or guidelines for the way they will pyramid into a position. These involve the size of the trades, and the point at which they take out additional trades. Some traders like to start with 25% of the total amount they want to trade ultimately, and put on different set percentages for each successive trade. Others will want to go right in with 50% of their ultimate goal, arguing that this gives a bigger gain overall. Of course it depends if the trade works out or goes into loss, whether this is in fact the best way.
However you choose to divide your trading capital, it is clear that by pyramiding you can keep control of your overall risk, and may finish up with a larger position and therefore larger gains on a good trade. Bear in mind that this is not appropriate for volatile stocks or even those that may gap open, and should be used only when you see a strong trend.
Pyramiding Up
This strategy is also referenced as ‘pyramiding up’. Pyramiding is a term used to describe the adding of more shares or contracts to your existing profitable position. As a stock rises in price, progressively smaller parcels are bought at higher prices until the desired position size is achieved. When done correctly, pyramiding is a highly effective way to increase your profits in a trade. It is what made Nicolas Darvas so successful and is the foundation of the Darvas method.
Scaling into positions entails buying more of a winning trade you have already entered. Perhaps that is why traders are averse to doing it – after all, you must pay more for the new spread bets than you did for the original ones in the same security, and that goes against the grain. But the way that many novices trade is bound to cause some problems in the long run – what they do is scale into a position if it falls in value.
Adding to Winning Positions
It is now fairly recognised amongst experienced traders that one of the best trading strategies you can adopt is to add to a WINNING position (as opposed to a losing position/averaging in). The other is of course to take profits before the trade turns into a loser!
This is easier said than done in practice because the theory is (which is against human nature, because when you lose you tend to try harder). Human nature dictates that if a share was worth buying at the previous price, it must be even more worth buying if the share price has gone further down. But this is flawed logic, as the original reason for entering the trade in the first place was in the expectation that the share price would go up, which it plainly has failed to do so far. So while it may feel unnatural, adding to winning positions essentially demands that you buy more when the share price has gone up, because then your position has started to look like a good one.
Adding to Winning Positions: Add to a winning position, setting break even stop losses as the winners come in. So in a worst case scenario you lose nothing or just very little. In a best case scenario you stand to make a huge profit.
Some generally accepted principles: Make each new trade smaller than the previous one when adding to winning positions; ensure the total trade has stops so you end up breakeven at worst after each pyramid; and work out in advance how many times you are going to pyramid your trade.
When planning a trade, I will usually pre-figure the total position I want to hold and will pyramid up to it, by adding 2 or 3 smaller parcels, each 1/2 of the previous one. For example, if I want to buy 7000 shares of XYZ, I may first buy 4000 and if the trade follows through according to my plan, I will add a further 2000 and finally a parcel of 1000 shares to complete my position.
However what most people do is:
Adding to Losing Positions: Add to a losing position i.e. don’t use pyramiding as an excuse to average down. Worst case scenario is bankruptcy. Best case scenario is breakeven or a small profit.
Very easy to type, but very difficult to do in practice… You place the stop loss at breakeven and then open a new position. Then, in my experience if the market goes against you it gets harder to keep the stop on the first position. If you do keep it and it gets hit, then by that stage your second position will be in loss making territory and you may get stopped out for an overall loss. There’s someone who trades at a high level I know, who has a huge number of breakeven trades or small losses everyday – but occasionally he gets a big winner. Because he backtests his strategies he is confident that adding to winners and running them (if that is his strategy for that market) will get him sufficient profits overall to absorb the losses when adding doesn’t work.
Small Losses and Bigger Winner
NOT
Small Wins and Big loser
Note: Needs to be a momentum trade (bolly breakout for instance) on a trend not a range trade, use a smaller timescale to identify periods of consolidation and use a OTO above the short term pause in price to make successive entries so only adding on resumption of momentum.
As Malcolm Pryor rightly pointed out to us, while he believes that pyramiding can be an effective tool with certain trading strategies, it may be one thing too many to think about when many traders struggle to even find a positive expectancy trading strategy. Many profitable traders simply enter their trade in one go and exit the whole position in one go, so beginning traders don’t need to worry that they might be missing out through not pyramiding.
Treating your money like a poker ‘roll’
This is a bit like winning at poker and moving to a higher limit table. If the cost to sit at a table is $100 you need say $3000 to play that level, when you get to $6000 you move to a table where the buy-in is $200. Similarly when you lose you move down to a $50 buy in table.
So if your capital is divided into say 200 ticks and you risk 10 ticks a trade you have enough for 20 positions to go against you. As you win, the process is exactly the same but the stakes increase as you improve. But most people will lose half their money and throw the lot in on a double or nothing Hell or Glory play. So in the end it all comes down to discipline.
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