Thoughts on Pyramiding

Discussions about Money Management and Risk Control.
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blueberrycake
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Thoughts on Pyramiding

Post by blueberrycake » 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

ksberg
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Post by ksberg » Sat Apr 10, 2004 2:02 am

bbc,
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 first danger is in thinking we know how other people are thinking ;-)

I've seen many different perspectives on pyramiding/scaling. Your supposition of risking "the market's money" is only one philosophy. Another view is that scaled entries (and exits) are a way of arriving at an average entry price. Another perspective is an aggregate position to capture the most reward without unduely taking full exposure on the first entry.

While pyramiding can be considered and measured as separate trades, the trades are also intrinsically linked. For instance, positions are often added in conjunction with decreasing risk exposure on the first position (e.g. tightening stops). Once into a trade, the two positions are 100% correlated. Yes, they will have different reward/risk, but you could say that the combined positions have an aggregate reward/risk. It may make sense to break apart and analyze the characteristics of stratefied entries and rationally determine a optimal approach.

My testing shows pyramiding makes sense over taking full risk on the first entry. My testing also shows me that inverse pyramid (decreasing unit load) gives the best blended reward/risk. Turtle uses constant unit load. I don't see these techniques reflected in your post.

There may be cases where "risking more on a following trade" makes more sense. In the case of scaling/pyramiding, remember that open trades are unrealized gain. I can't exactly remember my 'dynamic' sizing results (i.e. using open profits to re-size follow on unit load), but I seem to recall that it added portfolio volatility. I certainly didn't choose to include it.

Ok, long and short of it ... I don't think it makes sense.

$0.02,

Kevin

stancramer
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Post by stancramer » Sat Apr 10, 2004 9:55 am

I am in complete agreement with this analysis:
viewtopic.php?p=6154&highlight=#6154

ksberg
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More thoughts

Post by ksberg » Sun Apr 11, 2004 1:25 pm

BBC

I think the part that does make sense is looking at each scaled entry as a distinct system, doing analysis as appropriate, and choosing the strategy based on the results of that analysis. The aggregate systems and analysis reminds me of John Sweeney's Campaign Trading.

Cheers,

Kevin

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