On risk

Although successful pyramiding means building stakes in winners, there is some risk involved – you could build a big stake in a company that ultimately fails. Imagine having pyramided into Northern Rock in the good years, only to see your entire position ultimately wiped out.

So when pyramiding, it’s important to manage your downside risk by:

• Diversifying, so that all your eggs are not in one basket – the idea being to extract profit (as dividends, for instance) from one position to invest in a different position.
• Applying stop orders, which, as you saw in the previous article, is one way of freeing up risk capital from one position in order to make additional investments in another (or the same) position.
• De-pyramiding, by slowing down or reversing the pyramiding process as a position simply gets too big; which leads us on to...
  
  

Pyramid shapes

Obviously, the most stable pyramid is the one with a wide base; the one in which you invest decreasing amounts as the pyramid grows. You will have made bigger purchases at lower prices.

More adventurous investors might invest increasing amounts as the pyramid – and their confidence – grows – but top-heavy pyramids are more prone to toppling over. You will have made bigger purchases at higher prices, and so your position will erode more quickly if and when the positive price trend reverses.

My own preference for investing an equal amount at each level means that each contribution in fact represents a smaller amount as a percentage of the total position.

Multiple pyramids vs. single pyramid

I said earlier that one way to manage risk is to diversify into other positions – in other words, to start new pyramids. You start your first pyramid when a particular stock or other financial instrument (anything with a market price) meets your entry criteria.

When this position moves into profit, you secure some of the profit using a stop order – or you extract some profit in the form of a dividend – and look for something else that meets your entry criteria so as to start a new pyramid.

While keeping this in mind, the best candidate might still be your original stock, in which case you will add to your existing position – as in the following example.

Single pyramid in action

My concrete pyramiding example uses the price chart for Barclays (BARC). Having fallen along with other banking stocks in 2007-2008, Barclays staged an impressive recovery, with shares increasing in price by a spectacular 500% between March and May 2009.

No one rings a bell at the bottom of the market, so I couldn’t have known for sure that the price had bottomed-out in March; hence I would have been foolish to have committed all of my funds at that point.

But through a process of pyramiding, I was able to benefit from the uptrend while keeping my risk to a minimum. Here’s how:

• After seeing a classic double-bottom formation in March, I established an exploratory position, at a price of 75p in the form of a £1-per-point spread bet. It didn’t have to be a spread bet, but it was, and it happens to make the numbers in the example more logical. With no initial stop order, my value-at-risk was the full £75.

• The price rose and then paused for breath, establishing a support level at the beginning of April. I established an additional £1-per-point position at a price of 150p and applied a stop order (on both positions) at 125. Locking in profit from the first position and minimising risk on the new position.

• The price rose further and corrected to form a new support level in mid-April. I established a third position at a price of 200 and adjusted all my stop orders to 175. The combined secured profit on all of my positions was now £100 – £100 on the first position, £25 on the second position and -£25 on the latest position (it is a minus figure because the price might fall and trigger the stop at a loss).

• By the time the price trend had appeared to flatten out in May, I’d achieved a secured profit of £225, a 200% increase on my initial value-at-risk of £75, and with no compulsion yet to crystallise the profit by selling out. Most importantly: I had a guaranteed minimum profit – subject to my stop orders executing efficiently – at every step after the first.

You can ponder how much money I could have made by placing higher £10-per-point spread bets, or by making an ordinary investment of a meaningful amount at each step. Of course, if the price had moved against me, it would be a case of losing money rather than making it.

By Tony Loton, a trader and financial writer.

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