V.10:10 (436-438): A Guide To Pyramiding by Nauzer J. Balsara

A Guide To Pyramiding by Nauzer J. Balsara

Pyramiding, the process of adding to the number of contracts during the life of a trade, needs to be distinguished from the strategy of increasing or decreasing the trading size contingent on the outcome of a closed-out trade. Typically, pyramiding is undertaken with a view toward concentrating resources on a winning trade, but pyramids could also be used to average or dilute the entry price on a losing trade. Adding to a losing position is essentially a case of good money chasing after bad and so, in this article, Nauzer Balsara examines the concept of adding to profitable positions.

Critical to successful pyramiding is an appreciation of the concept of the effective exposure on a trade, which measures the dollar amount at risk at any point during the life of a trade. It is a function of the entry price, the current stop price and the number of contracts traded of the commodity in question. The effective exposure on a trade is defined as:

(a) for a short trade:

(current stop price - entry price)(number of contracts)

(b) for a long trade:

(entry price - current stop price)(number of contracts)

As long as a trade has not registered an unrealized profit, the effective exposure on a trade is positive and represents the maximum amount of capital at risk, assuming that prices do no gap through the stop price. A trade protected by a breakeven stop equal to the trade entry price has no effective exposure. For example, a trader who has purchased two futures contracts of June 1992 gold at $335 an ounce with a protective sell-stop a $330 is risking $5 an ounce, leading to an effective exposure o $500 per 100-ounce futures contract or $1,000 for two contracts. If gold continues to rally, and the protective sell-stop is moved up to $335, our trader is assured a breakeven trade, disregarding gaps through the stop price.