Adding to trades (also known as pyramiding).
This is one of the most important features to think about in your approach because it can dramatically improve the profitability of your winners if done effectively. If it is done poorly it could make you lose more money.
If your system has a win rate or win percentage below 50% then it’s obvious your winners will need to individually make more money per trade than your losses in order to break even. The first way to do this is to follow the age-old trading adage “cut your losses and let your profits run”.
The second way to do this is to “back a winner” to keep on winning.
As an example:
- if you buy one unit of stock Alpha at 100 and lose your money.
- buy one unit of stock Beta at 100, sell at 400.
- buy 1 unit of stock Gamma at 100 and lose your money.
- Your net result is 300 (stock beta) – 100 (stock alpha) – 100 (stock gamma) = 100 profit.
That would be an example where you simply let your profits run and because of your entry and exit rules you have a winner that is greater in value than the cost of your losses.
If however you bought one unit of Beta at 100, it went up, so you bought a second unit at 200, then it went up again so you bought a third unit at 300 and you sold at 400. Your total profit would be 600 less the cost of your losses being 200, so you’ve made a net amount of 400 instead of 100.
That’s a a dramatic increase of 400% in the profitability of your system. That example was in an ideal world and doesn’t specify how or under what criteria you buy the additional units. This is the hard part but it’s important to consider once you have a winner how can you truly maximize the value of that winner.
Also if you applied this approach to every trade would it mean that some of your winners get stopped out earlier and become less profitable because you have a bigger position size requiring a tighter stop early on?
As an example of how this can go wrong, think about the trade for stock beta getting to 300 , you buy a third unit and then the price drops to 0. Now you have a loss of 100 from stock Alpha, a loss of 100 from stock gamma and a loss of 600 from stock beta.
This is the impact of leverage and why the process of adding to Trades requires much thought and exploration of scenario analysis. To give some stimulation to ideas you might explore in adding to trades:
- Can you add to a trade which is trending higher when the price comes back to the 20 day or 40 day or 200 day moving average?
- Can you add to a trade when the price makes a new High or a new low in a downtrend?
- Can you add to a trade when it has already made a 3% move in your favour from the initial entry?
- Can you add to a long trade when fundamental news which is expected to be bearish either doesn’t move the price down or only down a small amount when it might be expected to drop the price a lot?
- Can you add to a trade when there is a spike in volume and the candle finishes in your favour? e.g. rejected the lows or posted a big bullish white body in an uptrend in a big volume day implying the price action is more meaningful.
- Can you add to a trade when it has posted 10 sessions of higher lows or higher highs?
- Can you add to a trade when there is a 50-61% retracement from the most recent high or low?
Some important considerations around adding to Trades include:
- How experienced are you in watching your profits decline ( do you have personal evidence to support your belief that you will get out with less profit instead of watching the big win turn into a big loss)?
- How does watching your profits decline rapidly make you feel? If you don’t like how that feels then you will need to set tighter stops ( how does this change your profitability – do you get stopped out earlier) or buy less aggressively ( so the value declines less aggressively) or change where you buy ( perhaps buy on a replacement or near the trendline instead of at a new High).
- Can you test how buying more will impact your existing winners? The first step is to print off or save a copy of a chart showing your winning trades to examine their behaviour from your point of entry to your exit. Obviously doing a mechanical backtest using defined trading Rules is the best way to show any inconsistencies but barring the technical ability or for those facing a time constraint it is a critical to do a quick scan of a chart.