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Editors Note: This article covers a forex trading technique called pyramiding, which is risky and should only be attempted by expert traders.
Everyone wants more money, right? If you are an active investor, there is a trick you can do to boost your accounts and don’t worry, it’s completely legal and on-the-table. But keep in mind, this investing trick could put a truckload of money in your hands, but it also increases your risk. It’s called Pyramiding.
By “trick” I mean more specifically, you can add more “size” to a profitable trade, which is used by some traders to increase their profits.
The first thing you should know is that this technique adds significant amounts of risk to trading. It’s not for everybody. First time traders shouldn’t consider Pyramiding at all. But if you’ve made a few trades before and have the discipline of a Shaolin Monk, you might consider using pyramiding to supercharge your profits.
And that doesn’t mean “just do it without thinking through the consequences for your trading”. Don’t go out and start pyramiding immediately because you read about it… rather you should seriously think through the pros and cons of the technique. And there are pros and cons.
Pros: • You might make more money – a ton more money • You’d learn about risk
Cons: • Could lose much more money • More complex to keep track of trades • Fewer winning trades
This is an advanced technique so not everyone knows what Pyramiding means. What is Pyramiding? Pyramiding is adding a bit more risk to a winning trade – by adding additional contracts as the trade moves in your favor.
Another reason to learn about Pyramiding is that if you’re trading, you’ll probably hear about it at some point and so it’s good to have reliable information on this risky technique.
Pyramiding doesn’t work great with every style of trading. Trend following, for example, is a strategy that works great with pyramiding because it’s longer term and if you’re adding to each contract, your potential gains are enormous. Pyramiding works by adding more contracts to the trade if the market moves in favor of the trade. But this alone isn’t enough information to use this technique successfully.
Penny Stocks, on the other hand, isn’t made for pyramiding because it’s more for smaller trades and would lose it’s effectiveness to add to each contract and drastically increase risk to the point of not being an option.
There is a quote from a famous trend trader, Ed Seykota about Pyramiding:
“Pyramiding instructions appear on dollar bills. Add smaller and smaller amounts on the way up. Keep your eye open at the top.”
It’s called “Pyramiding” for a reason- you should add less and less risk to the trade as it moves more and more in your favor. The definition of pyramiding is adding to your position size over the life of a trade.
Imagine your initial size for a trade is 3 contracts. With pyramiding, you’d still enter your initial position with a 3 lot. If the trade goes against you initially, you keep your size at 3 contracts.
This is in keeping with our general rule to “cut losses short”. You don’t want to add more risk to a losing trade.
But…if the market prices move in the direction of your trade, pyramiding will add more contracts to the trade.
This increases the risk, but it also magnifies any future gains. And because the trade is already profitable, in some ways you can consider Pyramiding to be “playing with the markets money”.
If you start with three contracts at the beginning of the trade, you’ll only add 2 contracts when the market moves in your favor. Then if the trade moves a bit more in your favor, you’ll add a bit more – only 1 contract this time.
The reason for this adding less and less as the trade becomes more and more profitable is simple: Risk. Just because the trade moves a bit in your favor doesn’t mean the price will continue to move in that direction.
The market will still move the same amount as before, and your account is still the same size. Pyramiding increases risk exposure of your account.
Risking 2% of the value of your account per trade is the absolute maximum amount you should consider per trade unless you seriously want to jeopardize your account. Anything more than 2% is likely to cause you misery and pain. And possibly lose your house, car, or spouse.
Pyramiding is a “good” fit for trend following, because the profitable trades tend to have a big enough price movement to keep the risk somewhat under control. I personally don’t use it because the risk doesn’t appeal to me, but I know many traders who love it and thrive on boosting their accounts by using it.
Also, pyramiding tends to reduce the number of winners. It makes the winners larger, but reduces their number. Fewer winners tend to make results more spikey.
Still, some trend traders do use pyramiding. The Turtles (a very famous group of trend traders) used pyramiding in their trading system. The turtles were traders with hands-on mentoring from some of the best traders in history.
Trend Following targets big trades with sustained moves in one direction. One other criteria of trend following is that it’s systematic – it uses pre set rules to decide almost every possible part of a trade even before it happens.
Trend Trading is Systematic Trading – so Pyramiding should be Systematic too. So with this in mind, any pyramiding for trend following would also be systematic. There will be regular rules on adding positions as the market moves in favor of the trade. If I were to create rules for pyramiding with any systematic trading system, I’d start with Matching the entry rules for the added positions to the entry rule for the current system.
Deciding how to move the exit stops for the added positions For example, you could have a system where you risk 1% on any trade. If you were pyramiding, you could add 2 more trades of .5% each, or you could add trades of .66% and .33%. Both of these would add up to 2% total risk, but the performace of the system would be different.
Then you will need to decide if you want to move the initial exit stop up as you add positions, or to let this stop remain in place and add stops specifically for the contracts you’ve added with the pyramid.
My tendency is to move the stop up and exit the entire position at one time, but others have different ideas. Having good rules in place allows you to make good decisions quickly – rules are basically decisions you make in advance of the actual situation.
You can tell I’ve just touched on this topic, but I wanted to cover the idea of pyramiding before you got bad information from some place else. It’s a risky technique – but if you have the emotional tools, it can be a useful, and profitable, tool.
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Michael Sankowski has traded 48 markets on 4 continents, made over 100,000 trades, and traded billions of dollars. He has a patent pending on a product that makes trading safer for currency investors. He is a CFA and CAIA charter member. Michael is a nationally recognized speaker. His easy-to-use trend trading system for individual investors is based on his proprietary indicators and is available at http://www.trendfollowing101.com/blog
