What 22 Years Of Testing Suggests About Pyramiding
Pyramiding, the process of adding on to an initial position as a trade progresses, is a strategy some traders strongly support and others criticize. We’ll discuss the advantages and disadvantages of this technique, and if it’s practical to use in your trading.
What is pyramiding?
Pyramiding is a strategy trend followers use to build a position. When they put on a position, they wait a certain period of time, and if the position moves in their favor they add more contracts or shares. They may repeat this process three or four times or more.
Should I pyramid?
This is the key question. There are many different types of traders. For example, there are traders who trade a diversified group of markets, from financial futures and stocks (U.S. bond futures and banking stocks) to commodity futures and stocks (such as crude oil and oil stocks).
These traders have an unassuming philosophy. They believe it’s not possible to forecast which sectors of the economy will produce a profit opportunity in the future, so they take what I call a “shotgun” approach. There is some merit in this belief, as even top Wall Street economists have a very difficult time forecasting the economy, being correct 50% of the time. Forecasting any economy is half art and half mathematics.
Then there are traders who believe they know approximately which sectors of the economy will produce profit opportunities in the future and thus concentrate their trading in these sectors. I call this approach the “rifle” approach. (A shotgun blast has a wide trajectory, while a rifle has a narrower, longer trajectory.) These traders believe they should concentrate on high-probability sectors and not waste their time and energy on other markets.
Here’s an example: A trader determines from his fundamental research that the economy is headed for a recession next year. Up until now, the economy has been in a stable environment and interest rates have been in a trading range. The trader would then allocate his capital to the bond market, because, if his prediction is right, he knows interest rates are poised to make a major move down as the Fed tries to get the economy out of a recession (triggering a major move in the bonds). Our “shotgun” trader also would have the opportunity to capitalize on this, but his positions would not be as big because his capital would be allocated to many other market sectors as well.
Case study: U.S. T-bond market
Lets examine a simple trend-following system that buys on dips against the long-term trend. The exact entry rules are not important because we are just illustrating the performance of any trading system with or without pyramiding. Table A shows the results of this system in the bond futures using pyramiding while Table B shows the same system without pyramiding.
| TABLE A: PYRAMIDING | |||
|---|---|---|---|
| Triple SMA Fader system, T-bonds, daily (8/25/77-8/26/99) | |||
| System Analysis | |||
| Net Profit | $1,220,250.00 | Open Position | $0.00 |
| Gross Profit | $3,243,687.50 | Interest Earned | $0.00 |
| Gross Loss | ($2,023,437.50) | Commission Paid | $0.00 |
| Percent profitable | 36.56% | Profit factor | 1.60 |
What is important to compare here is not the net profit for each system, but the profit factor. As we can see, Table A had a profit factor of 1.60 and Table B a factor of 1.58. This means that for every dollar that was lost, pyramiding made 1.60, while not pyramiding made 1.58. This is not a significant difference.
| TABLE B: NO PYRAMIDING | |||||||
|---|---|---|---|---|---|---|---|
Triple SMA Fader system, T-bonds, daily (8/25/77-8/26/99) | |||||||
| System Analysis | |||||||
| Net Profit | $207,500.00 | Open Position | $0.00 | ||||
| Gross Profit | $566,906.25 | Interest Earned | $0.00 | ||||
| Gross Loss | ($359,406.25) | Commission Paid | $0.00 | ||||
| Percent profitable | 37.85% | Profit factor | 1.58 | ||||
Conclusion
At first thought, pyramiding seems to make sense because you’re adding to your position as you make money. However, the long-term results don’t suggest there is an advantage to this strategy. Further, the profit stream from most system trading is very short and abrupt. In other words, most systems make all their money in very short time periods and spend the rest of the time taking losses.
This being the case, pyramiding would magnify losing periods because the positions that are added after the initial position would suffer losses. On the other hand, the profitable periods would be much more dramatic because the pyramiding tactic would produce huge profits in a very short period of time.
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