How Does Pyramiding Work?

Pyramiding is a method of increasing margin by using unrealized returns from successful trades. Pyramiding works by surrendering a minimal amount of previously owned shares in order to pay a part of the exercise price. The surrendered funds are used to purchase a larger amount of option shares. These shares are then surrendered back to the company so that the process repeats itself—with more funds added each time the action is completed—until the full option price is paid. You are generally scaling into a winning position, strategically executing trades once you've identified an extended move up or down.

Ultimately, the "optionee" is left only with an amount of shares equal to the option spread. The process of surrendering shares to pay some of the exercise price and then buying an increasingly larger number of option shares—with more funds added at each round—explains the trading method known as "pyramiding." 

Pyramiding uses leverage to gain a larger position size and, along with other speculative practices, can be risky and potentially can lead to magnified gains or losses. While some hedge funds and private investors employ this method, many do not have the ability to set up such trades. In addition, most hedge funds avoid taking this type of large risk within a single position. If you attempt to use pyramiding, you need to be really right, or the power of leveraging will definitely work against you. 

The key to success in pyramiding is to maintain a risk-reward ratio, which suggests that the amount you risk is never more than half of what you stand to gain, or your reward. Done correctly, you can compound your profit on a winning trade. But it takes a great deal of experience and discernment to recognize which trades are suitable for pyramiding. Only use pyramiding only when there's a strong trend in the market, and have an exit plan in place before you execute the first trade. Resist the temptation to get greedy, and always stick to your plan to minimize your risks, always keeping your eye on the correct 1:2 risk-reward ratio. (See also: Triple Screen Trading System.)

This question was answered by Richard C. Wilson.

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