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The first requirement for a pyramid is that your trading position actually be in profit. This may sound obvious, but you would be amazed how many traders violate this most basic of principles. Many traders and investors actually add to LOSING positions. There are various strange justifications for this, such as the idea that by doing so, you are “averaging” your entry price and thereby making it cheaper.
Here is an inviolable trading principle: Do NOT add to a losing position! It does not matter what you choose to call it, a losing position is a losing position. It has not proven itself, and there is no reason to think that a loser will turn into a winner.
Another dangerous principle is to add a larger size to your trade with each pyramid. This is called the inverted pyramid. It sounds insane but some traders have been known to do it. Understand this basic principle: if the market starts to move against you, your position will go increasingly negative very, very quickly! Indeed, if you think about this objectively, a given market move has a finite length. You don’t know the extent of that length, but you do know that it is finite, and that the market must eventually reverse. If that is the case, why one earth would you want to add progressively larger amounts to a trade as it moves closer and closer to the termination point of the move?
An interesting method proposed by Perry Kaufman, author of “Trading Systems & Methods” takes the notion of the finite length of a market move at face value and builds its pyramiding approach around it. Kaufman suggests that you place your entire position on at the very start of the trade, and progressively take it off as the move progresses. The idea is that since the length of the move is finite, by taking OFF your position as it progresses, you are actually reducing your risk and exposure. This approach may well suit a number of traders out there, but it will not suit everyone. For a start, you will always take your biggest trading loss at the very beginning of each trade, i.e. when the trend move you are betting on has barely proven itself and is hence least certain. If that is the case, why would you wish to place your heaviest bet at the precise time when the move is least proven? Apart from that, it does appear to go against the notion of staying with the trend (i.e. “the trend is your friend”) since you are actually gradually taking OFF the trade as the move proves itself. Finally, you cannot know the full extent of the move and hence may have reduced your position to relatively negligible levels, only to find that the market goes on and on… at precisely the time when you are LEAST invested in it.
The conventional way to pyramid is to add a smaller position to your trade as the market proves itself. The proportion you decide upon is up to you, the market you are trading, and also whatever analysis you have performed on this subject. Many traders would consider a pyramid size of 10-30% to be reasonable. In other words, if you are long 100 shares/contracts, then you would add another 10-30 shares/contracts IF your position is profitable. Some traders might be more aggressive, and it can also depend upon the probability of the market making the forecast move. However, you want to base the percentage upon the ORIGINAL position size, and not the current one. If you pursue the latter course, then you are getting into a disguised form of inverted pyramiding again, as your pyramid size will be getting progressively larger. Instead, it makes best sense to decide upon a fixed percentage of the original trade size, and only pyramid with that same number of shares/contracts.
WHEN do you pyramid? That is indeed the million-dollar question. This is also where most people go wrong, even if they have followed all the principles just outlined, they can still screw up at this point.
You need to be aware of a very basic principle: the market can always turn around and turn the profit on your pyramided position into a loss. That is what frequently happens. Moreover, because the trader has not thought out the matter carefully enough, the breakeven position on the entire trade, i.e. base position plus pyramids, is found to be dangling in mid-air. It is a price level that corresponds to nothing on the technical charts. Worse still, the unfortunate trader realizes that the original position would still be in profit now, despite the adverse market move... if only he/she had not put on that damn pyramid!
In many ways, you want to think of your pyramids as separate trades, each of which has to justify its own existence, and each of which has its own discrete stop loss level. This makes much better sense than simply allocating ONE global stop on the entire trade. As we have just seen, this breakeven level may have no market significance whatsoever.
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