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Pyramiding

Posted By Robert On Thursday, December 12th, 2013 With 0 Comments

Pyramiding means adding additional funds to an existing position when it moves in the right direction; thereby causing you to benefit even more if the price continues to move in the right direction. Pyramiding is a way of “backing the winners” that seems completely contrary to the more common practice (among newcomers) of “averaging down” the losers.

Here is a graphical example of what difference it could make to the eventual return by pyramiding from £1-per-point to £2-per-point at the right time by placing a second £1-per-point bet:

Pyramiding

There is no sure-fire rule for when it is best to pyramid, but from a risk management perspective a good rule of thumb is to never pyramid until the profit on the original position is greater than the risk of the new position – so that, in the worst case, you will at least have broken even. This is best demonstrated via a concrete example.

Pyramiding Example

In the following example for Enterprise Inns (which was a real-life pyramided trade) you can see how a first £10-per-point spread bet was opened at a price of 29p-per-share on 28 December 2011. The share price rallied and then a second £5-per-point spread bet was opened at a price of 51p-per-share on 6 March 2012. The net result is that the 22-point price move notched up between those two dates amounted to £220, and the smaller additional 16-point price move from 6 March until the end of the chart amounted to a larger £80. In total, a 38-point move generated a £300 paper profit.

At this point the £300 profit is not assured if the price falls back, but what if we raised the stop order to 57p-per-share in order to “lock in” some profit on both positions. That assures a profit of £280 + £30 = £310 as explained below:

If the price falls back then the first £10-per-point position is expected to stop-out for a profit of £280 [(57p-29p)x10) and the second position is expected to stop out for a profit of £30 [(57p-51p)x5), but those profits are only really assured if a guaranteed stop order has been used.

Some of the more gung-ho traders would point out that an original spread bet at £15-per-point would have generated a larger paper profit. Ah yes, but at double the initial risk for not double the profit. Pyramiding is less risky than betting the farm in the first place because you should not pyramid a second position at all unless the new risk-to-stop is more than covered by the assured profit on the original position.

More about Pyramiding

The pyramiding strategy will be most relevant to longer term position traders, but not all spread bettors will be position traders. The potential (or actual) day traders and swing traders among you will be glad to know that I have relegated a more in-depth discussion of pyramiding to my position trading guide.

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