Ask Colin

Isn't there an element of pyramiding in your multiple entry technique?

The detailed questions are:

I have had some difficulty in interpreting some aspects of your trading plan as set out in your video and notes. When you have the time could you help with the interpretation:

For illustration purposes you have assumed a static trading capital of $100,000. But in practice this figure is changing every day. For position sizing calculation purposes, one should probably recalculate one's trading capital periodically, say at the end of each month. So it is probable that the 2nd & 3rd part of your entry will, if there is some significant time lag between the entry parts, be calculated on different trading capital figures. So, for example, for the 1st part of the entry may be calculated on $100,000 while the 3rd part may be calculated on $110,000. This will alter the actual size of the parcel one buys to conform with the current 1% of trading cap calculation.

So for the first entry 1% = $1000 & the subsequent entry 1% = $ 1,100.

Your IDT example illustrates this well because of the time lags (page 133 of your notes)

1st point of entry (15/09/97)

2% of $100,000=$2,000/.29 = 6,900 shares.

3rd point of entry (18/11/98)

2% of $100,000=$2,000/.33= 6,060 shares

But it is quite feasible that trading capital significantly different 11 months later, say $115,000, so

2% of $115,000=$2,300/.33= 6,700 shares, significantly different to 6.060 above.

I assume you would in practice buy 6,700 shares, is this correct?

If so, isn't there an element of pyramiding as the profit on the 1st & 2nd entry points are included in the increased capital figure & is now reinvested. Also proportionately bigger parts are being bought at higher price levels?

A further issue is as follows: On page 137 you have written "Again we ignore the profits already available on the first two lots."

I am confused how this can be ignored as your 6% specific risk guideline can clearly be substantially violated if ignored.

6,900 x .33 = $2,277 (1st lot bought at .29 recalculated at current price)

10,000x .33 = $3,300 (2nd lot bought at .20 recalculated at current price)

TOTAL $5,577 = 5.6% of $100,000 trading capital

So, the 3rd lot should not be bought because it is too close to the max 6% specific risk maximum. By buying another 2% we are already near the 8% mark.

This rejection of a 3rd lot as above is quite a regular problem especially if one is entering in stages on a value chart as specific resistance hurdles are penetrated.

My response to this is:

These are highly intelligent and excellent questions, for which I thank you.

Before I try to answer them, may I say that there is very little written in the literature of trading about this - at least that I have come across. Quite a few people have outlined the basic money management calculation of position size - eg Tharp and Elder. I cannot recall anyone dealing with multiple entries to the one trade where they are not pyramiding. So, I have had to try to develop my ideas from first principles and I acknowledge that there are some problems with my practical answers, which I am not yet completely happy with.

The problems you outline are quite minimal if the multiple entries are quite close together in time and price. However, as you say, once the price has moved significantly from the original entries, our trading capital could have increased because of this trade and therefore we are technically pyramiding the profits. I tried to avoid this at one point in the calculations, as you noted, but you are absolutely right in pointing out that I have not dealt well with the pyramiding inherent in the second and third entries where the price has moved significantly.

I have never been completely happy with the solution I came up with. I want to thank you very much for raising it here, because it prompts me to start thinking about this before I start writing my book in November 2003.

In fact, there are two problems with my solution. One is the potential unintended pyramiding you have pointed out. The second is that the calculations for the second and third entries can become rather too complicated. Complication contributes to two problems - making mistakes and not appreciating the implications you have pointed out. I also think that most people will shy away from such complications.

I don't know that I can give you a definite best answer at this point, but my thoughts currently, and especially following your email, are:

The total capital used in the calculation should be reviewed when it has grown by about 10% from the last fix. This is more logical than using the elapse of time.

When the first entry is done, we determine what the maximum is that we will ever invest in that stock in this trade, based on 6% of capital at the time of the first entry.

Invest 2% of capital at the time of the first entry, each time, providing that does not exceed the amount that can be invested from the position sizing calculation.

Where the full 2% is not permitted on one entry, the shortfall may be added to the next entry - potentially there could be four entries on this rule.

An example will help explain how this would work:

Assume total capital of $100,000.

Therefore a maximum of $6,000 may go into this stock in this trade.

The aim will be three entries of $2,000.

Assume the first entry position size calculation allows us to invest more than $2,000. We would invest only $2,000.

When the second entry opportunity arrives, we would have another $2,000 we could invest. Assume the position size calculation allows us to invest only $1,800. We would invest only $1,800.

When the third entry opportunity arrives, we would have $2,200 to invest. The position size calculation will determine whether we may invest it all, or only part of it, leaving a balance for a potential fourth entry opportunity.

One caveat: In practice, I do not always get to the maximum of 6%. I may be stopped out before the position is fully built, of course, but what I mean here is that sometimes one of four things happen:

Firstly, I may think the trend looks too far advanced by the time I get second or third opportunities.

Secondly, I may see other trades that look better than continuing to build a previous one.

Thirdly, I may have started building positions in other stocks in the same industry sector and be unwilling to put too much more into the sector.

Finally, my market risk strategy may have reduced the amount of capital I should have in the market, so there are no funds free to continue building the trade.

I would be very appreciative of your further thoughts on this.

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