Pyramid trading, also known as pyramiding, is a trading strategy that advocates doubling down on a position only when the price of said instrument behaves according to expectations. It is a very conservative trading strategy that is aimed at lowering risk and allowing investors to decrease their chances of making losses in the long run. It is named eponymously after the investment pyramid, a portfolio allocation framework that keeps low-risk investments to the bottom and speculative investments at the top.
How does pyramiding work?
It wouldn’t be an exaggeration to say that pyramiding is a no-nonsense approach to investing. It is a very prudent approach as the trader will only invest further in a trade that is turning a profit and exhibits signs of upward movement. For instance, a trader who purchases 300 stocks, adds to it only when it starts to show a profit. If the stock continues to trend upward, they end up with a larger position and more profit (compared to having purchased larger volumes).
For instance, suppose that we are working with a limit of ₹1,00,000, and we do not want to risk more than 1% of the limit (i.e. ₹1,000). We define a ‘stop’ at that level to ensure that we don’t lose any more than that amount. To execute this strategy, we examine the stock charts and choose a level that corresponds to a former support level. The stop shall be defined slightly below the support level. If current prices are, say 70 paise away from the former support level, and we add a buffer to it (about 75 paise), we should be able to take about 1,298 shares (₹1,000/₹0.77). We round this figure down and opt for 1,200 shares to ensure that our risk stays below 1,000.
It takes advantage of upward trends to ‘separate the wheat from the chaff’ when it comes to trading. Pyramiding only applies to high-performing assets that are expected to maximize potential returns. When executed with caution, it keeps risk levels low as it is judged only based on past and current performance, never on future events. It does carry the risk of the investor paying more for every incremental investment but by the same token, ends up minimizing the downsides as well.
A pyramiding trading strategy has some obvious advantages, which are summarized below:
Flexibility: Because of the simplicity of the logic that guides it, a pyramiding strategy applies to both long positions as well as shorter ones.
Limits early withdrawal: Implementing a pyramiding trading framework directly addresses the issue of traders exiting every single time the stock shows signs of reversing. The trader is forced to be analytical and patient to ascertain if it’s a shift in trends or a temporary pause in momentum. With these insights, traders have ample time for reflection and can execute several trades in a single move.
Force of compounding: By adopting a pyramiding strategy, the trader only picks stocks that show consistent signs of growth. In the long run, this compounds the effect of gains in proportion to the initial investment. This establishes a reasonable symmetry between the possibilities of losses and gains.
Lowered Risk: Pyramiding is well recognized as one of the go-to strategies for conservative investors. Its approach of going slow and ‘getting a feel of the market’ prods investors to maintain a level head and evaluate their position multiple times before making any additional investments. The approach combined with the mentality it yields translates to a lower possibility of losses in the long run.
The advantages to pyramiding can also work against the trader in select circumstances. Here is a list of instances where things can go wrong:
Applicability: Pyramiding only works best in markets that are ‘trending’, i.e. poised for growth. This disqualifies a large portion of stocks as they might not necessarily fall into the category of a trending market.
Counter-Intuitive: Since every incremental investment costs more to buy into under this framework, the investor ends up paying more for a higher-performing stock over an extended period. Even in the face of a well-placed judgment on the future growth potential of a stock, investors will have to resist their temptations and take it slow.
Gap-sensitive: Pyramiding strategies are bound to experience difficulties when done in markets that are prone to experiencing ‘gaps’. A gap refers to discontinuity in a stock chart due to a sudden rise or falls in its price from the previous day’s close. Gaps can throw a spanner in the works by exposing traders to more risk. As a trader continually adds to their position, they stand to lose more in a large gap.
Lower-Profits: With so many mechanisms in place to limit the downsides, pyramiding also has the opposite effect. It shrinks the pool of profits by achieving an average entry price (due to slow, incremental investments).
Pyramiding is likely to get mistaken for ‘averaging down’, wherein a trader is encouraged to purchase additional shares in an existing position to decrease the average price of the stock to lower levels. This is far from the core principles of pyramiding as further investments are encouraged only upon seeing an upward movement in prices of existing positions.
As a conservative trading strategy that minimizes risk, pyramiding is designed to appeal to new investors and/or those who are very risk-averse. It’s important to remember that such a strategy only works in trending markets by maximizing returns without increasing risk. Pyramiding should be avoided in markets that are prone to experiencing gaps and traders should be advised to evaluate additional positions to ensure profitability even in case the market turns. It works best when used as a tool to mitigate risk and not merely to scale up order sizes.