Adding to Position (Pyramiding)

‘Pyramiding’ loosely means adding to your position in a trade, i.e. buying more shares that you already own. So when would you buy more shares in a company that you have already invested in? Many investors make the mistake of ‘averaging down’, which is purchasing more shares as the price is falling. The reason they do this is because they believe that if a stock was cheap when they initially purchased the shares, it must be cheaper now. This is a massive NO NO as it goes against the principle of setting up stop losses and getting out of the trade when your stop loss is activated. Furthermore, you have no way of knowing how far the price of the stock is going to fall. Remember – capital preservation is essential for a healthy and prosperous trading experience.

So don’t buy more shares if the price in that company is falling!

It is accepted that the price of shares do in fact trend. Therefore, adding to your position makes sense when you have confirmed that the price is trending up. So when do you add? How much do you add? And how often do you add?

You could keep it simple and base it on %s, i.e. if the price moves up 5% buy more. If it moves up another 5% - buy more again, and so on. Or you could base it on an Average True Range (ATR) movement, i.e. if the price moves up ½ ATR or 1 ATR – buy more.

Trading Example

I will keep it simple for this example and use the 5 % rule to demonstrate how adding to your position can increase your profits. This article should be read in conjunction with my post on ‘Position Sizing’. Remember that I only want to risk a maximum of $1000 per trade and I use 2 x ATR as my stop loss.

Chart supplied by www.incrediblecharts.com

On the 20/3/09 I buy 1136 CRG shares at the open for $8.00 for an outlay of $9088 (1). The ATR of CRG on this date is $0.44 (4) therefore, my stop loss is set at $7.12 (Stop Loss is: purchase price minus 2 x ATR). At this stage, the most I can lose is $999.68 (1136 x $7.12 = $8088.32)

$9088 - $8088.32 = $999.68

On the 24/3/09 the price of CRG has increased by 5%, i.e. it reaches $8.40 (2). I now decide to buy more. The ATR is now $0.43 (5) and once again I only want to risk $1000 on this trade. My stop loss is now set at $7.54. To calculate the number of shares I am now going to purchase I divide $1000 by 2ATR:

$1000 / $0.86 = 1163 shares. Therefore, 1163 CRG shares are purchased at $8.40 for an outlay of $9,769.

I now own 2299 CRG shares that have cost a total of $18857. If the stop loss of $7.54 is activated, I exit both trades therefore, I sell 2299 CRG shares at $7.54 and receive $17334.46 (a loss of $1522.54).

On the 5/4/09 the price of CRG has increased another 5%, i.e. it reaches $8.82 (3). I now decide to buy more. The ATR is now $0.39 (6) and once again I only want to risk $1000 on this trade. My stop loss is now set at $8.04. To calculate the number of shares I am going to purchase I divide $1000 by 2 ATR:

$1000 / $0.78 = 1282 shares. Therefore, 1282 CRG shares are purchased at $8.82 for an outlay of $11,307.24.

I now own 3581 CRG shares that have cost a total of $30,164.24. If the stop loss of $8.04 is activated, I exit all three trades therefore, I sell 3581 CRG shares at $8.04 and receive $28,792.128 (a loss of $1373).

Now in this example, I would exit all three trades on the 14/5/09 on the open at $9.23 due to my moving average rules. So 3581 CRG shares are sold at $9.23 and I receive $33,052.63 (a $2888.39 profit).

Had I not added to my position, I would have only owned 1136 CRG shares that were purchased on the 20/3/09 for $8.00. I would have sold them on the 14/5/09 at $9.23, receiving $10,485.28 (a profit of $1397.28 ).

Adding to my position increased my profits by $1491.11 which is a 107% increase.

An interesting observation comes out of this example. Whilst I conducted three separated trades and risked $1000 per trade, my overall risk ended up only being $1373. Whereas if I had conducted three trades in three separate stocks, my overall risk would have been $3000.

Why would you not add to your position to a trend that is working in your favour? With proper risk management strategies, you can increase your profits while lessening your risk. Caution: do not put all your eggs into one basket. I only add to my position twice.

Position Sizing – What is it and How to Apply it?

Position sizing is about deciding just how many shares to buy or sell and it is crucial to Money Management (as is setting a Stop Loss). I consider determining how much to buy or sell the single most important aspect of trading because using a position sizing strategy limits your risk which in turn gives greater confidence to enter the trade.

I have found that most traders conduct each trade with the exact same position size, e.g. they invest $10,000 into each trade. If you are a trader that fits into this category, hopefully this article will cause you to adapt your trading strategy – or cause you to develop one.

Determining Position Sizing

The first thing you need to do before determining your position size is to identify your maximum level of risk, i.e. how much money are you prepared to lose on a trade before you will exit the trade.

For the purpose of this article, I will demonstrate what I do. Many other traders do differently to this but this works for me. I have a trading account of $200,000 and each of my initial* trades will use no more than $15,000 of this $200,000. This allows me to have a minimum of 13-14 trades running at one time (diversification). I am prepared to lose $1,000 per trade before I will exit the trade. Before entering a trade, I need to know what the Average True Range (ATR) is for the stock I am trading (ATR is discussed in my third article that I posted on the 24/5/09).

I will now site an actual trade that could have been conducted by referring to the below chart.

Chart supplied by http://www.incrediblecharts.com/

On the 17 March 2009 you could have bought DJS at a price of $2.46 at the open. The 14-day Average True Range on this date was $0.11 (to the nearest cent). I use a stop loss of 2 ATR therefore, my stop loss for this trade would have been at $2.24 which is $0.22 below the entry price.

$2.46 – (2 x $0.11) = $2.24

Divide the amount that I am prepared to lose ($1,000) by 2 ATR ($0.22). This gives me the amount of shares I would purchase at $2.46 (4545 shares).

$1000 / $0.22 = 4545 (rounded to the nearest whole amount)

Therefore, on the 17 March, 2009 4545 DJS shares were purchased @ $2.46 for a total cost of $11,180.70. The stop loss is set at $2.24. If the stop loss is reached, I would sell:

4545 shares x $2.24 = $10,180.80

$11,180.70 - $10,180.80 = $999.90 which is the maximum I could lose from this trade.

As you can see in the chart above, the stop loss was not reached and I would fall back on my exit strategies to exit this trade. For interest’s sake, if you were still in this trade at time of writing you would be sitting on a nice paper profit of $5,181.30 as DJS closed at $3.60 on Wednesday the 27 May, 2009.

I do not factor in broker costs or slippage when I do my calculations. The reason for this is that broker costs are insignificant in comparison to the amount of the trade (as I trade CFDs my broker costs do not exceed $40 for the entire trade). Slippage very rarely occurs and I quite often get out of a bad trade before the stop loss is activated as other trading tools such as certain technical indicators have indicated to me that the trade is going bad before the price has reached my stop loss. As a result, my maximum loss can end up being less than the $1,000 limit I set myself.

*I referred to initial trade as this example doesn’t include anything on ‘adding to my position’ which I will discuss in another article.