In the process of trying to trade as efficiently as possible and maximize reward while minimizing risk, I’ve been looking at the money management part.
Most traders, at least retail traders such as I, will open a position, set a TP and a SL and that’s basically it.
For ease of understanding, let’s assume that all positions are the same size and that all SL are the same size.
The standard method results in, let’s say, a reward that’s two times the risk. That is, risk 1$ and gain 2$. Seems nice huh!
But is there any way that we could improve the reward [I]without[/I] increasing the risk?
Yes there is actually. It’s called pyramiding and has nothing to do with MLM scams or doubling down or any other of those crazy stupid things.
Pyramiding, if done properly, can increase your profits substantially without increasing the risk at all. To work really well you do have to manage to catch and ride a trend for some time.
Let’s have a look at the principle:
What we do to start with is nothing strange. First, we place a trade like any other, risking x% of the account. Nothing new here.
What happens next is the clever part: if, and only if, our trade goes into profit by at least the same amount that equals our risk, we can enter a new position in the same direction, risking again x%.
If the trade would turn on us now and go to hit our SL, we will only lose x% of our account, not 2x%. Why, because we move the SL on the first trade to BE when we enter trade number two.
That way, as long as the trend continues we can add to our trade size every time the previous trade has reached break even.
A quick comparison of the text book case:
- 1 Risk 0 Reward locked in (first trade is placed)
- 1 Risk 0 Reward locked in (second trade placed, first trade SL -> to BE)
- 1 Risk 1 Reward locked in (third trade placed)
- 1 Risk 3 Reward locked in (fourth trade placed)
- 1 Risk 6 Reward locked in (fifth trade placed)
- 1 Risk 10 Reward locked in (sixth trade placed)
7 SL hit: result is a return of 9 times the risk (10 Reward - 1 Risk)
Remember that the ordinary trade would have returned two times the risk (2 Reward - 0 Risk)
Most of you will immediately see the drawback of this - we need to get to step 3 before a hit SL results in a no loss trade, and we need to get to at least step 5 before things get really interesting. But if we can ride a long trend it’s plain to see that pyramiding is a very efficient way of increasing profits without increasing risk.
If we expect a trade to be able to give no more than 3 times the risk in return, pyramiding is not a good choice, but if or when we enter those rare, but wonderful positions that we expect to be able to ride for a good while, this can certainly be worth doing.
edit: here’s a good read at investopedia: Pyramid Your Way To Profits
