Thoughts on Pyramiding
Posted: Sat Apr 10, 2004 12:32 am
I've spent a lot of time recently thinking about pyramiding, and I've started to wonder whether the way people think about it really makes sense.
The standard argument for pyramiding is that when you make a small profit in a position, you increase your bet size, by risking "the market's money". What doesn't make sense to me is "the market's money" implies that you view profits from your open positions as being less yours than those from your closed positions. However, just because you haven't closed out your position, the open profit is still a real profit, and if you ran a fund, it would count towards your account value just as any closed profits do.
So if we equate open and closed profits, then pyramiding into a large position on a single commodity is no different that taking two separate trades, where if the first trade is profitable, you use some of the profit to increase your position size on the following trade. The same principle should then apply if you close out a profitable trade, and then initiate a new trade in a different commodity.
If we return to the standard pyramid where you enter at point A, then when price goes up to point B you increase your position size, we can view both of those entries as separate trades. Trade one: (enter at point A with your original position and "exit" at point B) and Trade two: (enter at point B with your original position plus the pyramid addition, and exit at whatever point your exit strategy takes you out at) The only way that it would makes sense to risk more at point B than at point A is if your risk/reward ratio is actually better at point B than at point A, which I dont think is usually true.
Therefore, the only way that pyramiding makes sense, is if we think of it as a general money management technique, where we always follow up a profitable trade with a larger position size on our following trade and not just as a way to build large positions in a single trend. You should therefore you risk more on any trade following a profitable trade, regardless of whether it's building a larger position from your original purchase, or an entire separate transaction.
Does this make sense?
-bbc
The standard argument for pyramiding is that when you make a small profit in a position, you increase your bet size, by risking "the market's money". What doesn't make sense to me is "the market's money" implies that you view profits from your open positions as being less yours than those from your closed positions. However, just because you haven't closed out your position, the open profit is still a real profit, and if you ran a fund, it would count towards your account value just as any closed profits do.
So if we equate open and closed profits, then pyramiding into a large position on a single commodity is no different that taking two separate trades, where if the first trade is profitable, you use some of the profit to increase your position size on the following trade. The same principle should then apply if you close out a profitable trade, and then initiate a new trade in a different commodity.
If we return to the standard pyramid where you enter at point A, then when price goes up to point B you increase your position size, we can view both of those entries as separate trades. Trade one: (enter at point A with your original position and "exit" at point B) and Trade two: (enter at point B with your original position plus the pyramid addition, and exit at whatever point your exit strategy takes you out at) The only way that it would makes sense to risk more at point B than at point A is if your risk/reward ratio is actually better at point B than at point A, which I dont think is usually true.
Therefore, the only way that pyramiding makes sense, is if we think of it as a general money management technique, where we always follow up a profitable trade with a larger position size on our following trade and not just as a way to build large positions in a single trend. You should therefore you risk more on any trade following a profitable trade, regardless of whether it's building a larger position from your original purchase, or an entire separate transaction.
Does this make sense?
-bbc