- Published on Saturday, 18 February 2012 12:16
- Written by Peter Pontikis
Trading is more than just about developing systems and setting stops. What do you do when your positions actually start to make money?
Jack Schwager observed in his famous 1990s book, the greatest traders are those traders who become expert at adding to their positions. These traders are expert in the discipline of pyramiding into profitable trades.
‘Pyramiding’ a position is where a trader seeks to enhance the leverage of an already leveraged trading vehicle. It is a trading method that lends itself eminently to the trading of futures where unrealized profits in an existing ‘live’ [ i.e. a still open ] position are available for opening new positions.
‘Pyramiding’ has come to mean several different things. For instance, Schwager uses it as an integral trend trading system while others use pyramiding as a way to improve the average entry price of a losing position. This strategy is essentially committing ‘good money to bad trades’ and is definitely not a recommended strategy! Other traders utilize pyramiding as a way to concentrate and magnify trading capital in winning trades.
It is in this last sense that pyramiding will be discussed here and should be used as a way to improve the dollar return on profitable trades. To pyramid into losing trades is to court financial disaster and is specifically not recommended.
To avoid disaster and to understand pyramiding, it must be clearly stated that proper pyramiding takes place only where assured unrealized profits exist on an unclosed trade. These assured unrealized profits form the deposit or margin for new futures positions being applied to the original and still ‘live’ trade.
Unrealized profits are an insufficient prerequisite for safe and correct pyramiding to occur. The unrealized profits must be ‘assured’ or ‘locked in’ when stops have been applied past a breakeven point in a trade. This occurs when the winning trade has progressed far enough to allow the stop on a long trade to be placed above the entry level or alternatively in a short trade, the stop is able to placed under the entry price.
Once unrealized profits have been protected by a stop – thus becoming ‘assured,’ you have the trading capital that forms the basis of pyramiding. This fresh capital is simply the difference between the entry level of the underlying trade and the current stop loss price times the number of open contracts. Of course, in the case of a long trade it is where the stop price is above the entry level [and in a short trade where the stop price is below the entry level] times the number of contracts open before commission and slippage.
Also note that your net capital-at-risk is the difference between your new stop level and the current market price before commission and slippage. Understanding that capital-at-risk is a way of understanding the amount of your account capital that is at risk to market price fluctuations before commission and slippage is taken into account at any point in time.
Returning to our original trade – and assuming that it is moving into in-the-money status, your capital-at-risk has also expanded. And here is the rub. What do you do with this winning trade? Do you take profits – exiting and foregoing fresh opportunity? Do you do nothing? This is also a favourite – another name for decision paralysis! But going back to John Moulton’s comments there is a middle way that preserves your capital and keeps the profitable trade delivering [hopefully] fresh profits – and that is to add to your winning position.
This sounds riskier than the first two propositions. But in pyramiding, we go through an initial process that actually makes it safer for your capital.
This process restricts your capital-at-risk or at least reduces it by adjusting the stop loss closer to the market price. In effect, this locks in more unrealized profits and makes them ‘assured’ and simultaneously cuts the amount of your capital-at-risk. Crucially, this new slab of assured unrealized profit becomes fresh capital available to be deployed in your money making favor. Now the precise method or magnitude used to adjust your stops should only be a function of your assessment of the technical risks of the trade. Only one’s risk appetite should have primacy over this rule and this is in the end a personal preference.
Pyramiding can be seen as the act of reinvesting a trade’s profits back into the same trade, giving the ability to leverage and magnify the profit potential on the trade. But crucially, correct pyramiding must be done only with the ‘safe’ assured unrealized profits, not just unrealized profits – as these are still subject to price fluctuations.
This is trading profit that is no longer subject to market price risk – and can be made available to be used as deposit to apply fresh futures [in effect new trade exposure] to the existing profitable trade. This is done without the trader having to increase his or her capital exposure beyond the capital initially committed to the trade.
Now with this fresh capital, one opens new positions in the direction of the original trade ensuring the new trades’ capital-at-risk is never more than the assured unrealized capital, while remembering to make an allowance for slippage and commission. Effectively, you are compounding the benefit of the trend in your favour using ‘untaken’ profits. Thus, the profits are magnified.
As each new incremental trade moves further into the money, the capital-at-risk expands. To reduce capital-at-risk, while at the same time ‘releasing’ new layers of now assured unrealized profits for fresh pyramiding, the stop losses are re-adjusted. The process continues until either the stops are hit or one is in the enviable situation of taking profits at leisure or to scale back positions incrementally.
By following this program – it is possible to avoid the usually disastrous pitfall where traders pyramid and increase capital commitment into a seemingly profitable trade – but ignore the actual magnitudes of the capital-at-risk also being pyramided. Losing sight of the inherent vulnerability of the whole trade to even a minor adverse move.
There exists a trading risk that a pyramided trend ends prematurely and leaves very little profit to the trader once stops and expenses are settled compared to a trade that is unpyramided. But this is a worst-case scenario that still compares favourably with the ‘do nothing’ strategy.
The management of unrealized profits and losses in a sense should be the same. If one is ruthlessly intolerant of losses, [remember that we are here to make money – being right is of secondary importance] then the same should apply to ones net exposure or unrealized profits. It is patently a way to contain financial risk while at the same time magnifying the potential of the winning – and still winning trade.
Balsara, Nauzer.J. Money Management Strategies for Futures Traders John Wiley & Sons Inc., Brisbane, 1992
Schwager, Jack. Getting Starting in Technical Analysis John Wiley & Sons, Inc. New York 1999