Stocks & Commodities V. 10:10 (436-438): A Guide To Pyramiding by Nauzer J.

Balsara

A Guide To Pyramiding
by Nauzer J. Balsara

Pyramiding, the process of adding to the number of contracts during the life of a trade, needs to be
distinguished from the strategy of increasing or decreasing the trading size contingent on the outcome of
a closed-out trade. Typically, pyramiding is undertaken with a view toward concentrating resources on a
winning trade, but pyramids could also be used to average or dilute the entry price on a losing trade.
Adding to a losing position is essentially a case of good money chasing after bad and so, in this article,
Nauzer Balsara examines the concept of adding to profitable positions.

C ritical to successful pyramiding is an appreciation of the concept of the effective exposure on a trade,
which measures the dollar amount at risk at any point during the life of a trade. It is a function of the
entry price, the current stop price and the number of contracts traded of the commodity in question. The
effective exposure on a trade is defined as:
(a) for a short trade:
(current stop price - entry price)(number of contracts)
(b) for a long trade:
(entry price - current stop price)(number of contracts)
As long as a trade has not registered an unrealized profit, the effective exposure on a trade is positive and
represents the maximum amount of capital at risk, assuming that prices do no gap through the stop price.
A trade protected by a breakeven stop equal to the trade entry price has no effective exposure. For
example, a trader who has purchased two futures contracts of June 1992 gold at $335 an ounce with a
protective sell-stop a $330 is risking $5 an ounce, leading to an effective exposure o $500 per 100-ounce

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Stocks & Commodities V. 10:10 (436-438): A Guide To Pyramiding by Nauzer J. Balsara

futures contract or $1,000 for two contracts. If gold continues to rally, and the protective sell-stop is
moved up to $335, our trader is assured a breakeven trade, disregarding gaps through the stop price.

NET EXPOSURE
Hypothetically, once the stop is moved past the breakeven level, the trade registers a locked-in, or
assured, unrealized profit. The effective exposure now turns negative, indicating the trader's funds are no
longer at risk. A negative exposure measures the locked-in unrealized profit on the trade. The trader
might now wish to expose a part or all of his locked-in profits by adding to the number of contracts
traded. Let p denote the fraction of assured unrealized profits to be reinvested into the trade. The value of
p could vary from trade to trade. Whereas a p value of one suggests that 100% of assured unrealized
profits are to be reinvested into the trade, a p value of zero implies that there will be no pyramiding.
Therefore, the additional exposure on a profitable trade is defined as:

Additional exposure on profitable trade =

(p) (Assured profit per contract) (number of contracts)
The net exposure on a trade with assured unrealized profits is the sum of the effective exposure on the
trade and the additional exposure resulting from reinvesting all or part of the assured unrealized profits.
Therefore,

Net exposure = Effective exposure + additional exposure

Whereas the effective exposure on a profitable trade is necessarily negative, the additional exposure
could be either zero or positive, leading to a zero or negative net exposure.

FACTORS INFLUENCING REINVESTMENT

A trader's willingness to expose unrealized profits is an important, albeit subjective, factor influencing
the reinvestment fraction p. For our purposes here, let us assume that a trader has no qualms about
reinvesting a fraction of his or her unrealized profits should conditions warrant such reinvestment. A
continuation chart pattern (Figure 1) provides an opportune time for pyramiding a profitable trade,
inasmuch as the continuation pattern provides a definitive clue as to the potential risk and reward on a
breakout from the pattern. Symmetrical triangles, wedges and flags are the most commonly observed
continuation patterns, all of which offer definite guidelines in regard to trade reward and risk.
For example, a breakout from a flag suggests that prices are likely to move a distance approximately
equal to the length of the flagpole in the direction of the breakout. A logical place to set an exit stop
would be just below the lowest point of a bull market flag formation and above the highest point of a bear
market flag formation. Armed with this knowledge, the trader can now estimate the reward/risk ratio for
the continuation pattern. There is a direct relationship between the reward/risk ratio and the reinvestment
fraction p. The higher the reward/risk ratio, the stronger the case for a higher p value. Conversely, a
reward/risk ratio close to 1 suggests extreme caution in plowing back assured unrealized trade profits.

COMPUTING INCREMENTAL CONTRACT SIZE

The incremental contract size is a function of the assured unrealized profits to be reinvested into the trade
and the dollar amount at risk per contract. Specifically, the formula for computing the incremental

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contract size is:

( p)(assured unrealized profits)( number of contracts)

permissible dollar risk per contract

Referring to the previous example, assume that gold is currently trading at $350 an ounce and the
sell-stop is raised to $345 an ounce, leading to a permissible risk exposure of $500 per contract. Since
two contracts of gold were purchased at $335 an ounce, we have an unrealized profit of $15 per ounce, of
which $10 is locked in by the protective stop as an assured unrealized profit. This translates into an
assured unrealized profit of $2,000 for two contracts.

Pyramiding a futures trade is a means by which to enhance the

leverage of an already leveraged trading vehicle.
If 25% of this amount or $500 is to be reinvested, the trader should buy one additional contract at $350
with a sell-stop for the entire position at $345. If p is set at 0.50 or $1,000, the trader should buy two
additional contracts at $350. Finally, if the trader wishes to reinvest 100% of assured unrealized profits or
$2,000, this would entail buying four additional contracts at $350 with a sell-stop for all six contracts set
at $345.
When the number of contracts added to a position is less than the number of contracts currently traded,
we have a conventional, scaled-down pyramid. Conversely, when the number of contracts added to a
position exceeds the number of contracts currently traded, we have an inverted, scaled-up or leveraged
pyramid. When the number of additional contracts is the same as the number of contracts currently
traded, the formation is symmetrical as opposed to a pyramid.

IMPACT OF PYRAMIDING
The shape of the pyramid determines the sensitivity of overall profits to changes in futures prices, as is
evident from Figure 2. Assume that prices fluctuate from a high of $355 to a low of $345. With no profit
reinvestment, the profit spread associated with these price fluctuations is $2,000. In the case of the
scaled-down pyramid where 25% of assured unrealized profits are reinvested into the trade, we observe
marginally higher profits at a price of $355 and marginally lower profits at a price of $345, leading to a
wider profit spread of $3,000. The profit spread is maximized at $6,000 in the case of the leveraged
pyramid case when 100% of assured unrealized profits are plowed back into the trade. Profits are
maximized in the event of a favorable price move but are reduced to zero should prices retreat to the stop
price. The scaled-up pyramid magnifies the double-edged nature of the leverage sword, suggesting that a
100% plowback of assured profits should be reserved for those special situations when the possibility of
an exceptionally high reward justifies the risk.

CONCLUDING
Pyramiding a futures trade is a means by which to enhance the leverage of an already leveraged trading
vehicle. Reinvesting a fraction of assured unrealized profits into the trade is a conservative approach to
pyramiding, inasmuch as the trader is only risking a portion or all of the locked-in profits on the trade. In
the worst-case scenario, if 100% of assured unrealized profits are plowed back into the trade, the trader

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risks losing this entire amount, ending up with a breakeven trade.

Nauzer Balsara, Ph.D., is a Commodities Trading Advisor and an associate professor of finance at
Northeastern Illinois University, Chicago, IL. He is actively involved in futures and options trading .

REFERENCES
Balsara, Nauzer J. [1992]. "Avoiding bull and bear traps," STOCKS & COMMODITIES, August.
___ [1992] . "Using profitability stops in trading," STOCKS & COMMODITIES, May.
___ [1992]. Money Management Strategies for Futures Traders , John Wiley & Sons.

FIGURE 1: Continuation patterns are a period of consolidation during a trend. The flag pattern will have
a downward slant with the line of resistance and the line of support being approximately parallel
Technicians expect the flag formation to mark the halfway point in the current trend .

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Stocks & Commodities V. 10:10 (436-438): A Guide To Pyramiding by Nauzer J. Balsara

FIGURE 2

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