Imagine placing a bet on a horse. You might stake money on the horse, hoping with crossed fingers that your horse comes out good and storms past the others. If you’re successful and you win, you might feel a hint of regret that you didn’t invest more money, thereby maximizing your returns from the gamble. This is of course natural – if you only had more confidence in your bet, you could have walked away with five or ten times the winnings!
But what if you could increase the size of your bet after the first couple of furlongs when your horse already had a strong lead? This is effectively the impact of pyramiding a position, which allows you to heavily capitalise on trading positions that are moving in your favour.
What is Pyramiding
Pyramiding is a traditional trading strategy of increasing a position size by using margin from unrealized gains. Put simply, Pyramiding means that you add to an existing position as soon as price moves in your favor. A trader would then start with a small initial position and as the trade unfolds add to his winners and slowly develop a bigger position.
Issues with Pyramiding
Complexities can often arise from pyramiding in markets which have a tendency to “gap” in price from one day to the next. Gaps can cause stops to be blown very easily, revealing the trader to more risk by constantly adding to positions at higher and higher prices. A large gap could mean a very large loss on a larger position.
A trader who adds contracts to an existing, winning position averages his price up. For example, you bought 10 contracts at an initial price at 100 and when price was at 110, you added another 10 contracts. Now your average entry price is 105. This means that when price turns on you just a little bit, you will see your unrealized profits evaporating much sooner. This can quickly result in a variety of psychological problems where the trader starts mismanaging his positions and is also more likely to make impulsive trading decisions when price retraces a little.
Final Verdict: It only works for large trends
Pyramiding only works for large trends and when you catch a runner early. Otherwise, you have to add to your position very often, which creates problems of evaporating profits and the need to manage positions too tightly as we have mentioned earlier. Or, you can only enter one or two of your scaling in entries and can’t reach your full position size often, not maximizing your profits.
So even though you might be a trend-following trader, with a pyramiding technique you need to be even more selective and only look for potentially large trends.
It’s far too easy to fall into the trap of thinking that the market isn’t going to reverse on you. Remember, markets ebb and flow. Even the strongest trends experience pullbacks to the mean. Have an exit plan outlined before entering the first trade in a series.
Here are a few things to keep in mind when using the pyramid trading strategy.
- Only use the pyramid strategy in a strong, trending market
- Always define your support and resistance levels before the trade
- Know your exit plan and maintain a proper risk to reward ratio at all times
- Trail your stop loss behind each new position in order to mitigate your exposure
- Keep things simple by using the same position size for each block of buying or selling
- Don’t get greedy – stick to your plan!
Above all else, just remember to use pyramiding sparingly. This isn’t a technique you want to use on every trade or even every other trade.
But if you can catch just three or four pyramided trades per year, you’re looking at a profit potential of 60% to 80% from a mere handful of trades. Combine that with the fact that you’re only risking 2% each time, and you have a strategy that is as favorable as it is profitable.