What Is Pyramiding?
The term pyramiding refers to a trading strategy that increases positions in securities by using unrealized profits from successful trades. As such, pyramiding involves the use of leverage to increase one's holdings by making use of an increased unrealized value of current holdings. This strategy is considered very aggressive but can result in big gains if executed properly. Because it involves leverage rather than cash to execute trades, pyramiding is a riskier strategy and should only be used by very experienced traders.
- Pyramiding is a trading strategy that involves the use of leverage to increase the size of a trader's position.
- It works by adding to a profitable position when an asset performs well and continues to show upside potential.
- This isn't a strategy meant for novice traders.
- Experienced traders have a better handle on how to use leverage and are better able to sustain the risks associated with pyramiding.
- The pyramiding of options involves surrendering a minimal amount of previously-owned shares to pay a part of the exercise price.
How Pyramiding Works
Investors have a number of trading strategies at their disposal to help increase their positions in their securities and to help boost their profits. Some of these techniques are fairly conservative, which means they are safe and involve minimal risk. Others can be fairly risky. Pyramiding is one of these complicated risky strategies.
Pyramiding works by starting with a small position, then adding to it when the asset performs well and continues to show potential for upside. This means traders add multiple positions to their holdings. As such, traders can realize large profits when their position grows. An investor who pyramids uses additional margin from the increasing price of the security in their portfolio to purchase more of the same asset.
As mentioned above, pyramiding is generally considered a risky trading strategy for inexperienced traders, so it should only be executed by those who have a proven track record of success and are better equipped to control and handle the risks that come with pyramiding because:
- it works for large trends and only when you enter the position early enough
- the strategy requires the use of leverage or borrowed capital
- investors must have significant capital in their accounts, holding at least 25% of the total value of securities as a maintenance margin
Whether pyramiding involves just one or a few securities, the risk of a portfolio concentration increases with each level of the pyramid. If the trend or momentum doesn't continue—especially during periods of panic selling—the trader may experience major losses. As such, experienced traders generally diversify their holdings in different sectors to minimize the risk.
Keep your emotions in check if and when you use strategies like pyramiding.
Pyramiding in Options
An option is a type of derivative that is based on the value of the underlying security. Buyers of options contracts have the choice but not the obligation to buy or sell the underlying asset. When you integrate pyramiding into your options strategies, you surrender a minimal amount of previously-owned shares in order to pay a part of the exercise price. These surrendered funds are used to purchase more shares.
Shares are then surrendered back to the company so the process repeats itself with more funds added each time the action is completed until the full option price is paid. The trader is left with a small number of shares equal to the option spread. Since pyramiding relies on leverage to gain a larger exposure to a specific trade, gains and losses will be magnified.
Pyramiding vs. Pyramid Schemes
Pyramiding is a legitimate and very legal trading strategy, and should not be confused with pyramid schemes, which are illegal in many countries. Pyramid schemes are fraudulent investment scams that put investors in hierarchies, taking money from new investors to pay returns to existing ones.
Rather than selling products or services, pyramid schemes lure investors by promising them large returns, usually higher than traditional investments on the market. Those who invest early generally receive these promised returns as newer investors are recruited. But these schemes eventually collapse when they fail to bring in new investors. Those on the bottom of the pyramid rarely recover their capital, let alone any returns.
Pyramiding is a form of averaging up, which involves purchasing securities that you already own at a higher price.
Example of Pyramiding
Let's use a simple hypothetical example to show how pyramiding works. Suppose you have a margin account with $25,000 and you're looking for a really great opportunity to profit using pyramiding. For the sake of this example, let's assume you can use the entire balance of your account to make your investment.
You notice that the share price of Company X dropped from $25 to $4 and there's good news on the horizon for the company. You use 30% of your capital ($7,500) to enter into a position and the stock jumps to $10 following a new product launch. You use the money you've made to purchase more shares in the company when the stock price jumps more than 2%, adding another 10% of your remaining capital ($1,750) to your position. You keep adding to your position each time the stock moves up,