We've all heard the age old adage, cut your losses short, and let your profits run. Yet the vast majority of traders don't use this concept to its fullest. The proper application of this single, pivotal piece of advice can be the difference between showing a profit at the end of the month, and showing a loss. This method 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.
So if a company is trading at $20 per share, and our stop loss is at $17.50, we can lose $2.50 per share by buying. If were willing to lose no more then $2500, then $2500/$2.50 = 1000 shares. So we should purchase 1000 shares for this trade.
With your standard trade, that would be hit. An order to sell at a certain price, and order to buy at a certain price, and a stop loss. When your pyramiding your profits though, there's an integral extra step. When the stock has gone up in price, and you have some profits, you add MORE to the position. Lets say it goes up to $22.50, and you decide to move your stop loss up to $21.00. You now have 1000 in gains if you get stopped out. To pyramid your profits, you add that 1000 in gains to your risk amount for the trade, for a total of $3500. Since its now at 22.50, and we can risk up to $3500, then we should purchase another 2300 shares. (3500/1.5 = 2334).
So to recap. Stop loss at 21, we bought 1000 shares at 20, and 2300 at 22.50. If it goes down to 21, we gain 1000 on the first 1000 shares, and lose 3450 on the batch of 2300 shares, for a total loss of $2500 " the original risk amount. However, if it goes up to 25 as we originally forecast as our profit target, we've made $5000 on the original 1000 shares, and another $5750 on the second batch of 2300 shares. This is a total gain of 10750, while never risking more then $2500 in capital. The same idea can be applied to shorting as well. Its all about doing more of whats working, and less of what isn't.
This strategy is useful both for long term investors, and for shorter term traders. Long term investors can use this to scale into upwards trending stocks to safely generate massive profits, while shorter term investors can use this strategy to minimize risk, while maximizing their overall gains.
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.
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.
So if a company is trading at $20 per share, and our stop loss is at $17.50, we can lose $2.50 per share by buying. If were willing to lose no more then $2500, then $2500/$2.50 = 1000 shares. So we should purchase 1000 shares for this trade.
With your standard trade, that would be hit. An order to sell at a certain price, and order to buy at a certain price, and a stop loss. When your pyramiding your profits though, there's an integral extra step. When the stock has gone up in price, and you have some profits, you add MORE to the position. Lets say it goes up to $22.50, and you decide to move your stop loss up to $21.00. You now have 1000 in gains if you get stopped out. To pyramid your profits, you add that 1000 in gains to your risk amount for the trade, for a total of $3500. Since its now at 22.50, and we can risk up to $3500, then we should purchase another 2300 shares. (3500/1.5 = 2334).
So to recap. Stop loss at 21, we bought 1000 shares at 20, and 2300 at 22.50. If it goes down to 21, we gain 1000 on the first 1000 shares, and lose 3450 on the batch of 2300 shares, for a total loss of $2500 " the original risk amount. However, if it goes up to 25 as we originally forecast as our profit target, we've made $5000 on the original 1000 shares, and another $5750 on the second batch of 2300 shares. This is a total gain of 10750, while never risking more then $2500 in capital. The same idea can be applied to shorting as well. Its all about doing more of whats working, and less of what isn't.
This strategy is useful both for long term investors, and for shorter term traders. Long term investors can use this to scale into upwards trending stocks to safely generate massive profits, while shorter term investors can use this strategy to minimize risk, while maximizing their overall gains.
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.
About the Author:
Don't even THINK about trading another stock before checking out Jordan's website on Stock Trading Stategies. Learn about Stock Option Stategies, Exchange Traded Funds, shorting and more by visiting the Stock and Options Guru!
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