The term "pyramiding" is not the same as "averaging down," which is a term used to describe a strategy in which an unprofitable position is placed in a position at a price that is less than the initial price, which in turn lowers the entry cost of the position. It is a way to increase a position to maximize the benefits of assets that are performing well and increase the returns. The tendency to average down is a riskier option since the asset already has shown weaknesses, not strengths.
From the perspective of a trader, the pyramiding process lowers risk. This is because the rules for pyramiding require traders to start with a small amount, and they must determine an appropriate stop price. If it is the case, and only if the position is successful, it is possible to add more size. If the trade is not performing well after the addition of size, then the initial gains could decrease the effect of any loss. However, when the trade is performing well, the extra size drastically increases the profit. This keeps the initial risk at a low level while offering huge opportunities for profit.
Why It Works
This is because a trader can only add positions that are making profits and showing signs of strength that continue to grow. These signals can be repeated when the stock reaches new heights or when the price cannot return to its previous lows. In essence, we're benefiting from the trend by increasing the size of our position every time we see a wave in that trend. The benefit of pyramiding is that the risk (in terms of loss maximum) is not required to grow by adding the profit of an existing position. Initial and previous additions will show a profit before a new addition is added; previous entries offset the potential losses from newly added positions.
When the trader begins to employ pyramiding, the risk of profit-taking too early is significantly reduced. Instead of taking a break at any sign of a possible reverse, the trader is obliged to become more observant and be aware of whether the reversal is an in-between moment or a change in the direction. This gives the trader the understanding that they are not required only to make one trade at a particular time; however, they can also take several trades in an event.
In other words, instead of making a single trade for 1,000 shares at one point, traders could "feel out the market" through the initial trade of 500 shares and further trades as they earn profits. By taking advantage of pyramiding, a trader might have more than the 1,000 shares they could have traded in one go as the three or four trades could lead to the position being 1500 or even more shares. This does not increase the risk of the initial position since the original position is less, and the additional entries are only made when every previous entry is generating profits.
Putting it Into Practice
If you employ this method effectively, you could earn additional income without taking on additional risk. Let's say you're already engaged in an income-producing trade. You decide to boost the profit you could earn from this transaction. Then you may purchase additional shares of stock and then add them to your account. But, with this latest batch of shares, it is not making your stop loss the same level as the other order you placed.
Instead, you should put the stop loss near the point where you place the new order, but with some flexibility to move. If the stock declines in value, you're not losing significant funds. If the stock appreciates, it is possible to earn more than you would be in a position to make if you held on to the initial amount.
Problems with Pyramiding
Problems could arise from market pyramiding that has the habit of "gap" in price from one day to the next. These gaps can cause stop-loss to blow up very easily and expose traders to greater risk by expanding positions at ever-increasing prices. A gap of this magnitude could result in the loss of a significant amount. Another concern is if there are massive price changes between entries. This could cause the position to be "top-heavy," meaning that the potential loss from the latest additions could wipe out any profits (and possibly greater) that the previous entries have earned.
