by Amanda Harvey
What is Pyramid Trading?
Pyramiding is an investment strategy in which an investor increases the size of their position by buying additional shares. This is done to capitalize fully on an investment that is performing well, and is basically the opposite in theory to averaging down. While the additional shares are purchased at a higher premium, due to the fact that their price is rising, the goal is to increase the overall return the investor expects to receive.
Pyramiding in its truest definition means increasing the size of the position using margin, or borrowed money, but for most investors the focus is on the strategy as a means of making more of a successful trade rather than whether the money used is the investor’s own or margin.
What Are the Advantages of Pyramid Trading?
One of the key benefits of pyramiding is that it allows the investor to increase their position and their potential profit, without increasing their risk. In order to make sure that this control of risk is attained, a trailing stop loss follows the direction of the investment, and secures the profit that has already been attained.
When to Pyramid
The time to undertake pyramiding is when a market is trending. The premise of the pyramiding strategy is to ride the trend, and this will obviously not apply well to choppy markets. The retracements experienced in a choppy market will likely put the trade out of the running before it has had a chance to flourish, by triggering the stop loss.
A Word of Warning
Even in a trending market, this is a potential downside to implementing a pyramiding strategy. While using a trailing stop loss as a very important component of successful pyramiding strategy as it controls the risk while allowing the trader to increase potential profit, there is a chance that the trade may be stopped out by a market retracement, making it a break-even scenario rather than a winning trade. This is a worthwhile payoff, however, for the chance to execute those really profitable pyramid trades without exposure to unnecessary risk.
Structuring a Pyramid Trade
As the shape of a pyramid depicts, the initial investment is usually the most substantial, and following that, the position is increased in quantities which are becoming both smaller and more highly priced. With latter additions to the trade, the percentage returns may not be great, but they still augment the overall profit, and the high percentage return is achieved on the amount initially purchased.
One approach to pyramiding is for the trader to determine the amount of shares that they would eventually like to hold, and to break this number down into three or four progressively smaller quantities to use as the stages of scaling into the pyramid. The first amount might be 40% of the desired holding, followed by 30%, then 20% and finally 10%.
One reason that it is advisable to make the largest portion of the investment earlier in the pyramid trade is that a newer trend tends to be stronger, so this is the time to establish a solid foothold.
For a stock that is trending strongly, executing a pyramid trade can be a great method of really running with a winner, while keeping risk under control. There are, as in any form of trading, potential pitfalls to watch out for, but properly executed, this strategy can be very effective.