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What is pyramiding and how is the best way to do it?

What is pyramiding? The best definition I have is from The Language of Money by Edna Carew:

In the context of investments, using unrealised profits from say, futures trading, as security to borrow funds to buy more investments, such as additional positions in the futures market.

Although Edna bases her definition on the futures market, it can be applied to trading on margin in the stock market as well, where margin lending is available.

To understand how it works, lets say you need 10% margin on a position. You buy $100,000 worth of Westpac shares. You will need to put up $10,000 margin on this position (borrow $90,000).

If your Westpac holding goes up in value to $110,000, you now have $10,000 of profit in your margin account and can use this to buy more Westpac shares, thus pyramiding your position.

It is called pyramiding because you build one position on top of another like a pyramid.

The problem with pyramiding is that each time you do it, you move the breakeven price on the total of your positions closer and closer to the latest price. To avoid this, traders have learned from the earliest times that the safest way to pyramid is to add a smaller parcel each time, so that your average price is biased away from the current price. Hence, "pyramid", which implies a structure with a wide base and tapering height is most apposite. This gives you room to move if there is a correction. If your average price is too close to the current price, a small correction will take all your profits away and maybe plunge you into losses.

The exact proportions in which you add to your position is a matter of how much risk you want to take or can tolerate. There is nothing set in concrete. The market will allow you to self-destruct if you want or to be as conservative as you wish.

Pyramiding is a very high risk strategy. Like all gearing or leverage strategies, you are taking on significant financial risk on top of the market risk, liquidity risk and specific risk that you already have.

My own personal strategy is not to use any leverage at all, so pyramiding is also out of the question. Indeed, I use a kind of reverse strategy where instead of putting on all of my position at once, I will build it as the trend is confirmed. This is not pyramiding, because I am not using unrealised profits, but simply allocating money to a stock and then building the position in stages. The risk is lower than putting on all of the trade at once, because if it hits a stop-loss before the trend is confirmed, I take a smaller loss on the part position, than if I had put it all on in one go.