Pyramid those profits!

by: Jordan J. Weir

We’ve all heard the age old adage, cut your losses short, and let your profits ride. Yet the vast majority of traders don’t use this concept to its fullest. The proper application of this single, pivotal piece of advice, is usually the difference between showing a profit at the end of the month, and showing a loss. This method is known as “pyramiding your profits”.

The art of pyramiding your profits begins with good risk management. You should risk no more then 5% of your portfolio on any given trade, and many experienced traders use numbers as low as 2-3%. This doesn’t mean someone with a $50000 portfolio can only invest in $2500 worth of a companies stock, it means that when they are setting their stop loss, they must be cognizant of how much they can lose on the trade.

This can be easily demonstrated with an example. Let us say we have company XYZ trading at $20. There’s strong support at $18, so we set a stop loss for 17.50. This means we have a potential $2.50 loss per share. If we are risking $2500, and can lose up to 2.50 per share on this one, 1000 shares should be our maximum position size.

Instead of selling shares as the stock goes up, you buy more to take advantage of continued strength in the trend! Pyramid those profits!

Now here is where the idea of pyramiding your profits comes in. If you think that $20 stock is going to $25, then with your 1000 shares, there’s a potential for $5000 in profits. Not bad at all, but that number could be much higher. After that $20 stock goes up to $22.5, you move your stop loss up higher, possibly to around $21.00. Now you’ve locked in gains of $1000, and you can add that to your risk amount of $2500 for this trade. You now have $3500 to risk on this trade. Since you can lose $1.50 a share from where you currently are, $3500/1.50= 2334. This means you should increase your position by another 2300 shares.

Now let’s analyze your position for a second. You bought 1000 shares at 20, and 2300 at 22.50. If it goes to 25, then you made $5000 on the original 1000 shares, and another $5750 on the second set of 2300 shares, for a total gain of $10750. If it goes down to your stop at 21, then you made $1000 on the original 1000 shares, and lost $3450 on the second set of 2300 shares, for an overall loss of $2450 (about the same as the risk you were willing to take on).  Without pyramiding, you’d only make $5000, and risk the same $2450 attempting to get it. The same idea can be applied to shorting stock as well. Just remember – add to your position as you become profitable, but keep your maximum loss relatively constant factoring in the unrealized gains.  For longer term positions, you can (and should) lower your maximum loss to break even, and then to a profit over time.  Consider using a trailing stop at 10%, and then add more to the position on breakouts, keeping an eye to never buy so much as to exceed your max loss amount.

This strategy is useful both for long term investors, and for shorter term traders. Long term investors can use this to scale into upwards trending stocks to safely generate massive profits, while shorter term investors can use this strategy to minimize risk, while maximizing their overall gains.

The interesting thing about this strategy is while it’s almost the opposite of some conventional wisdom – you never go broke taking a profit – it does strongly adhere to the idea of cutting losses short and letting profits run. The key is to do more of what’s working, and less of what isn’t, and that’s exactly what this kind of trade accomplishes.

The art of pyramiding your profits is essential to long term success in the stock market. They say that even some of the best traders are only right 50%, 40%, sometimes even only 30% of the time, but as that example showed, by pyramiding your profits, your gains will far outweigh the small losses you occasionally take.