Stock Trading Strategy: Pyramid Your profits!

By Jordan Weir

Are you one to throw caution to the wind, or do you cut your losses short, and let your profits ride? It may surprise you to realize that while many traders think they cut their losses short, and let their profits run, there is a simple technique that will allow them greatly amplify those profits, while keeping their losses manageable. This technique is known as pyramiding your profits.

In order to properly pyramid your profits, you must understand a basic tenant of risk management. This tenant alone is enough to bring many an unprofitable trader to profitability, but only once combined with the idea of pyramiding profits, can its true utility be realized. This tenant states that no more then 5% of your portfolio should be at risk during any trade. Thus someone with a $50000 portfolio can risk $2500 on a trade. This doesnt mean they cant invest more then $2500, but it means that when setting a stop loss, your initial position size should be based on the $2500 number.

To determine your position size, what you do is you take the amount your willing to risk, and divide that by the amount your risking per share (the difference between the stock price, and your stop loss). So on a $20 stock, if your stop loss is at 17.50, and your risking $2500, then you do $2500/2.50 = 1000 shares. Your position size should be 1000 shares.

Now lets say the stock then moves to 22.50, and you move your stop loss to $21. At this point, you've looked in $1000 in gains. To pyramid your profits, you then add shares to the position based on the profit made so far. At this point, you have made $1000 in gains, and your risk amount was $2500. Add these numbers together, and then divide by the difference between the current stock price, and the stop loss to get the number of shares you should add to the position. So 1000+2500=3500/1.50=2300 shares. By doing this, you greatly increase how much you make if it continues to go up, while still keeping losses minimal should it go against you.

Now lets analyze your position for a second. You bought 1000 shares at 20, and 2300 at 22.50. If it goes to 25, then you made $5000 on the original 1000 shares, and another $5750 on the second set of 2300 shares. If it goes down to your stop at 21, then you made $1000 on the original 1000 shares, and lost $3450 on the second set of $2300 shares, for an overall loss of $2450 (about the same as the risk you were willing to take on). The same idea can be applied to shorting stock as well. Just remember " add to your position as you become profitable, but keep your maximum loss relatively constant factoring in the unrealized gains.

Yet the applications of this strategy are important not just for the short term trader; it can be used by long term investors as well. Assuming its an up trending stock, long term investors would be well served to start with smaller positions, with a stoploss, and essentially add to the position on breakouts. This allows you to profit from the frequent megatrends in the market, while being taken out of the market if it begins going against you.

You may have heard the saying, you never go broke taking a profit. This idea is the polar opposite to pyramiding your profits, and is in fact, dangerous. To succeed in the investing world, your profits must be substantially higher then your losses, and that is whats accomplished by a trading strategy such as pyramiding your profits. Cut your losses short, and let your profits run.

The art of pyramiding your profits is essential to long term success in the stock market. They say that even some of the best traders are only right 50%, 40%, sometimes even only 30% of the time, but as that example showed, by pyramiding your profits, your gains will far outweigh the small losses you occasionally take. - 23223

About the Author:

Don't even CONSIDER trading another stock before checking out Jordan's website on Stock Trading Stategies. Learn about Stock Option Stategies, etfs, shorting and more by visiting the Stock and Options Guru!