When it comes to trading, there are different schools of thought when it comes to management of a winning position. Some traders prefer to buy multiple shares or contracts and then scale out of the position as profit targets are hit. Others prefer to scale into a larger position as the market moves in their favor, also known as pyramiding.
Don’t Add to Losers, Add to Winners
The idea behind this strategy is to put on an initial position and add onto it as the market moves favorably. If performed correctly, pyramiding can potentially increase profit potential significantly, while not necessarily adding additional risk.
To control risk, especially as the position size grows, the use of trailing stops must be employed. Ideally, the market will move significantly in the desired direction to the point that stops can be placed at break-even or better levels.
Can You Show Me An Example of a Trade?
Suppose a trader believes that shares of company ABC have reached a bottom after a large sell-off and are now trading at $40 per share. The trader could initiate a long position by purchasing 100 shares at $40. An initial stop loss might be placed at $39 per share.
After buying the shares at $40, the stock begins to rally over several days and is now trading at $42 per share. At this point, the trader could elect to purchase another ten shares at $42. Because the trader is long 100 at $40 and long another $100 at $42, the break-even level on the position is now $41. The trader could move their stop up to this break-even level at this time.
The stock continues to climb, and a few days later is now at $44 per share. At this point, the trader could decide to buy another 100 shares. Being long 100 shares from $40, $42 and $44 would make the break-even level of the position $42 per share. The trader could place a stop loss order at this level.
The stock keeps climbing and two weeks later is now $48 per share. Rather than enjoying a nice long position from $40 per share, the trader has pyramided the position and is now making profits on 300 total shares. At this point, the trader could elect to place a stop loss order on the entire position at $46 per share. If the trader is stopped out at this level, they would have made $600 on the first 100 shares, $400 on the next 100 shares and $200 on the next 100 shares.
This would equate to a position profit of $1200. This is double the amount of profit that would’ve been made if only the first 100 shares were purchased.
Why Would I Want to Pyramid a Position?
Perhaps the biggest benefit of this strategy is the reduced risk at the initiation of the trade. If the trader is long and wrong, he or she will get stopped out on only the first 100 shares, whereas if a trader bought 300 shares at trade initiation, they may be stopped out on 300 shares.
The trick to pyramiding a position is where you add to a position and how you manage the stops. While you can add to positions at specific increments, you may also consider adding on a breach of support or resistance or other key technical point.
As always, risk should be considered first and managed. Make sure you trade with stops and move those stops based on market movement. As your position gets larger, losses can accrue faster therefore you must be aware of your break-even points. While pyramiding a position can potentially produce larger profits, it can also produce larger losses. Sudden, significant reversals can and do occur in markets and you must try to make sure you don’t let a potentially good trade turn into a loser.