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Every investor and trader seeks to maximize their profits in the stock market with different trading approaches. One such approach is pyramid trading which involves adding to the profitable positions for benefiting from a well-performing instrument. However, it is important to thoroughly understand the intricacies of the pyramid to ensure the minimization of risk and maximization of profit.
Dive in as we explore how pyramid trading functions and its advantages.
What is pyramid trading?
Also referred to as pyramiding, pyramiding trading technique is a strategy that involves doubling on a position that showcases favourable price movements. The strategy is aimed at lowering risks for traders and investors and making way for better returns in the long run.
This strategy is named after the investment pyramid which keeps low-risk investments at the bottom and the other speculative investments at the top.
How does pyramid trading work?
Pyramiding trading is a prudent investment strategy where the trader invests more funds in an instrument only when it is showing a positive upward trend. They invest more only when the asset shows a price rise which helps them get a large position as well as more profits. This training strategy is only applicable to high-performing assets that have a possibility of maximizing profit returns.
It helps in minimising the risk when invested strategically as it takes into account a stock’s past and current performance and not future expectations. Keep in mind that there is a risk of the investor paying more for every incremental investment but they also minimize the downside parallelly.
Advantages of pyramid trading
With an understanding of what pyramid trading entails, let us now look at the key advantages of the pyramid trading technique. These include:
- Flexibility
The pyramid trading strategy is useful for both traders and investors as it applies in the long as well as the short run. As a result, the strategy is flexible for usage in varied ways.
- Minimizes early withdrawal
With the implementation of the pyramid trading technique, the traders no longer exit the investment as soon as the signs of reversing show up. The traders become more patient and analyse the shift in the prices to assess whether they are temporary or recurring. As a result, the traders can thoroughly analyse the trade and execute their trade with fewer transactions.
- Power of compounding
Under the pyramid trading strategy, the trader only invests further in securities that show good growth. As a result, they benefit from the compound gains in proportion to the investments in the long run. It helps balance the symmetry between the profits and losses in the long run.
- Risk minimisation
Another benefit of engaging in pyramid trading is that it is an apt strategy for conservative investors. This is because investors measure the growth and success of the securities on the go before investing more funds. It is a slow investment process and helps minimize the investment risks.
Disadvantages of pyramid trading
While there is a range of advantages yielded by engaging in pyramid trading, there are also certain shortcomings to consider. These include:
- Applicability
The pyramid strategy is suitable for markets that are growing and trending. As a result, a large number of stocks that do not fall under this category are not suited for this strategy.
- Counter-intuitive
Since the investments are made at an increasing price under this strategy every time, the cost of investing keeps increasing over an extended period. As the investment keeps growing the price of the stock also rises. Even while it will help earn profits in the long run, the constantly increasing purchase price cannot be neglected.
- Gap sensitive
It is difficult to implement the pyramid strategies in markets that experience gaps, and a discontinuity in the stock chart due to the sudden fall or rise in price compared with the previous day’s close. This can not only cause inconvenience but a trader can also lose more in large gaps as they constantly keep adding more funds.
- Low profits
Since the pyramid strategy focuses immensely on reducing the downside, it might sometimes also impact the profits. Due to the slow incremental investments, it might sometimes shrink the profits with an average entry price.
Conclusion
The pyramid trading strategy is best suited for new investors or those who are risk-averse. It must be avoided in markets that are prone to gaps and also are not trending. The best way to utilize the pyramid strategy is by using it in combination with other strategies to ensure profitability in case of sudden market turns. As a result, use the pyramid trading strategy as a tool to mitigate risks and not entirely as a strategy to scale up your order sizes.
FAQs
Pyramid trading is a strategy that focuses on increasing a position that is showcasing favourable price increases and a good market turn.
Pyramid trading is a useful strategy to mitigate risks and invest more in securities that are performing well. However, it is recommended to combine it with other indicators to ensure that the decisions made are foolproof.
The advantages of the pyramid strategy include flexibility, minimal withdrawals, power of compounding and risk mitigation.
The challenges of the pyramid strategy include applicability, counterintuitive approach, gap sensitiveness and low profits.
To minimise pyramid-related risks, use risk management, set up clear loss-stop orders, have a good exit strategy and continuously monitor your investments.