Introduction:
Stock markets are prone to fluctuations. As an investor or trader, you strive to make maximum profits when the shares move in the speculated direction. However, sometimes it might happen that after you’ve sold your shares, their prices keep moving upwards and you lose out on the possible profit-making opportunity.
Several stock market traders face this issue almost daily. But do you know how you can solve this conundrum? The answer is by using the pyramid trading strategy.
While it can be challenging to predict the highs to which a stock can move, using the pyramid trading strategy can help you make full use of bullish momentum and maximise your profit. Continue reading to understand pyramid trading, how it works, and the associated advantages and risks.
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What is Pyramid Trading?
Pyramid trading refers to constantly consolidating your position when the price of a stock is moving in the anticipated direction. Subsequently, you keep adjusting your stop loss to protect your investments against a possible trend reversal. The act of using the pyramid trading strategy is known as pyramiding.
Pyramiding is a prudent trading strategy during bullish markets. It helps an investor maximise their profits during a bull run while lowering the chances of incurring losses in the case of a trend reversal. The strategy derives its name from an investment pyramid, wherein low-risk investments are kept in a high volume at the bottom and risk-prone investments at the top.
How does pyramid trading work?
To use the pyramid trading strategy, you need to keep buying and accumulating shares when it is going through a bullish phase. When the stock is at its highest peak, you will end up with a larger position, resulting in lofty returns.
For example, suppose you have purchased 1,000 shares of a company ABC at Rs. 100 per share. Your initial investment amount is Rs. 1 lakh. You do not want to lose more than 5% of your capital, so you put a stop loss at Rs. 95 per share.
Suddenly, news came in favour of the company ABC, and as a result, the value of its shares began surging. You perceive it as a good opportunity to use the pyramid trading strategy and add 100 shares every time the value goes up by Re. 1 and lift your stop loss by the same amount.
Considering the value of the share surged to Rs. 117 before a trend reversal, let’s calculate the total profits you will make:
The total number of new shares you will buy = 17 x 100, i.e., 1,700
Total shares you will have at trend reversal = 1,700 + 1,000, i.e., 2,700
Final stop loss at Rs. 112
Profit you will make on your initial shares = Rs. (12 x 1000), i.e., Rs. 12,000
Your additional profits = Rs. [(100 x 11) + (100 x 10) + (100 x 9) + (100 x 8) + (100 x 7) + (100 x 6) + (100 x 5) + (100 x 4) + (100 x 3) + (100 x 2) + (100 x 1)], i.e., Rs. 6,600
Your overall loss = Rs. [(100 x 5) + (100 x 4) + (100 x 3) + (100 x 2) + (100 x 1)], i.e., Rs. 1,500
Your net profit = Rs. (12,000 + 6,600 – 1,500), i.e., 17,100
As you see in the above calculation, you can make an additional profit of Rs. 5,100 or 42.5% by using the pyramid strategy.
Advantages and limitations of pyramid trading
The advantages of using the pyramid trading strategy include:
- It is a simple-to-use strategy. All you need to do is keep accumulating stocks and shifting the stop loss when the market is moving in the anticipated direction
- Intraday traders can use this strategy for both long and short positions
- It safeguards investors from early withdrawals during bull runs due to the fear of missing out (FOMO)
- It helps investors maximize their profits with minimum risk
The limitations include:
- For pyramiding to work, the market must move continuously in an upward direction for a certain period
- Investors may need a high capital to execute this strategy
- If the trend reversal comes early, this strategy may lead to a significant loss
To conclude
Pyramiding seems enticing as it allows you to maximize your profits during a bull run. However, as an investor, you must consider both pros and cons before executing this strategy. With Motilal Oswal, you can open a free Demat account and seamlessly start investing in the stock markets.
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