By Jason Pearce
Reward vs Risk
George Soros once said, “It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”
His comments address the subject of the reward-to-risk ratio on a trade. If the payoff of a winning trade is multiple times larger than the risk and subsequent loss on a losing trade, then you can net out a profit even if you have a lot more losing trades than winning trades.
This is why Paul Tudor Jones only takes a trade where he expects to get a minimum of a 5:1 reward-to-risk ratio.
Jones said, “Five to one means I’m risking one dollar to make five. What five to one does is allow you to have a hit ratio of 20%. I can actually be a complete imbecile. I can be wrong 80% of the time, and I’m still not going to lose.”
Simple Math
To calculate the reward-to-risk ratio on a trade, you have to know where the position is being entered, where the initial protective stop is being placed, and where you expect the market to go if the trade is successful.
The difference between the entry price and the initial protective stop tells you the risk on the trade.
The difference between the entry price and the minimum price you expect it to get to if you’re right is the potential reward on the trade.
Just divide the potential reward amount by the initial risk amount and, voilà, you will get the targeted reward-to-risk ratio for the trade.
Building the Great Pyramids
Now that you know how to determine the reward-to-risk ratio on the trade, I want to discuss a strategy that one can use to potentially increase the reward side of that ratio for any given trade.
Unlike in poker, where you have to up the ante and increase the amount of money you must risk in order to stay at the table, this strategy can allow a trader to keep the initial risk size the same –in some cases, even lower the amount of risk on the trade- and capture even more of the upside of a winning trade.
What I’m talking about here is building a pyramid. No, this is not some new MLM scheme like your dead-beat cousin Eddie is trying to get you to sign up for. This is a legit way to ramp up your profits on a winning trade.
Pyramiding a position simply means that you continue to add more and more contracts or shares as the market moves in your favor. You increase your position size as the trend proves itself and your profits grow.
No Averaging Down
It is important to understand that pyramiding a position is not like the traditional strategy of dollar cost averaging where you continue to add a predetermined amount to your investment in time increments like the guy who socks away $500 each month into his mutual fund portfolio.
It’s certainly not where you average down on a position and buy more and more shares of a sinking stock, either.
Quite the opposite.
In pyramiding, you only add to your position when you’re in a trending market that is moving in your favor.
Furthermore, when more contracts or shares are added, the protective stop orders for all the previously acquired contracts should be moving up as well in order to reduce/eliminate the risk on these contracts. At least, that’s the right way to do it. Otherwise, all you are doing is taking bigger risks with bigger positions.
From my point of view, adding more contracts without trailing the stops on the other positions is not pyramiding; it’s simply engaging in bad risk management.
Rookie Pyramid-Builder Mistake
Unfortunately, a lot of new commodity traders first learn about pyramiding with the worst application possible. This is a financial nuclear meltdown just waiting to happen.
The novice trader might read a get-rich-quick trading book or talk to some sleazy broker that teaches them to buy a futures contract and add more just as soon as it has a big enough open profit to cover the margin for another contract.
This sort of pyramiding is the most aggressive way to apply the strategy…and the most incorrect way to do it! So let’s go ahead and talk about this misapplication first and put it to rest. Knowing what not to do is just as important for your trading success as knowing what to do.
Recipe for Disaster
The margin for a 5,000 bushel wheat futures contract is currently around $1,500. This represents a price swing of 30 cents (5,000 bushels * 30 cents = $1,500).
Suppose a trader has $50k in his account and he buys a September wheat contract on a breakout at $5.40. He could put in a buy stop order to buy another one when it rallies 30 cents to $5.70 as the initial contract purchased at $5.40 would show an open profit of $1,500 and provide the financing for an additional contract.
This all seems harmless at first. A single contract with fifty grand to back it and one more contract when the market moves in the right direction. But watch how crazy and how fast this can escalate…
The trader can place an order to buy another contract just 15 cents higher at $5.85 instead of 30 cents higher at $6.00. This is because an additional 15-cent gain on two contracts is $1,500.
Or the trader could elect to be a little more patient and instead put in an order to buy two futures contracts at $6.00 instead of one at $5.85.
If the trader were to use the latter and more “conservative” choice, he could simply put in buy stop orders to double up every time the wheat market moves an additional 30 cents higher.
Let’s suppose our wheat trader gets “lucky” and catches a weather market in the grains where the market just shoots to the moon and makes hardly any pullbacks along the way. That’s the sort of trade that fortunes are made of. What happens if wheat rockets north of $8-per-bushel like it did in the summer of 2010?
The trader would have purchased one contract at $5.40, one additional contract at $5.70, two contracts at $6.00, four contracts at $6.30, eight contracts at $6.60, sixteen contracts at $6.90, thirty-two contracts at $7.20, sixty-four contracts at $7.50, and (gasp!) one hundred and twenty-eight contracts at $7.80.
That’s a total of two hundred and fifty-six wheat contracts that the trader is holding, folks. I hope they’re not gluten-intolerant…
Oh, and when wheat touches eight dollars the account would be sitting on an open profit of $638,500. What trader doesn’t dream of that?!
Jenga!
This nearly thirteen-fold increase in account size, brought about by an aggressive pyramiding strategy, is the siren song that lures the novice traders into the markets. They only pay attention to the profit potential and hope to match Soros’ net worth with just a few trades with their $50k trading stake.
Here’s what they are not taking into account. With two hundred and fifty-six wheat contracts on, every one-cent move in the price of wheat creates a profit or loss of $12,800 on their trading account and a mere ten-cent hiccup would rip an astronomical $128,000 from their account.
Notice what happened when wheat finally cracked the eight dollar mark in August of 2010: It rocketed to $8.41…and then promptly fell apart, like a high-stakes game of Jenga gone bad.
Wheat closed ‘limit down’ at a price of $7.25 3/4 that day.
From the day’s high to the close, this huge pyramided position dropped in value by $1,475,200. (That’s nearly one and a half million dollars, just in case the commas aren’t registering in your brain.)
By the way, once wheat traded to $7.46 1/4 the account value hit zero.
By the day’s close of $7.25 3/4, the account was in a deficit to the tune of $261,900. The trader is completely on the hook for this amount.
And that’s assuming he could have gotten out at the limit price. If it was locked limit, the trader would have exited in the next trading session at an even worse price when the market gapped lower.
What?!
Although this is what the September wheat contract actually did in the summer of 2010, the pyramided trade is a theoretical example. However, I can testify to the fact that scenarios like this can and do happen with alarming frequency. I watched a trader run $20k into $100k in a matter of weeks and then crash it into a deficit of $20k in a matter of days. It was accomplished during a good old-fashioned weather market in soybeans.
I also know of a mailman with a $50k net worth who ran a $25k account up to nearly $500,000…and then down into a deficit of nearly $1 million by aggressively pyramiding in the silver market this same way.
With a net worth of just $50k, it’s quite a burden to owe a clearing firm $1 million.
I could go on, but you should get the point by now. This sort of aggressive pyramiding scheme that increases your account exponentially on the way up will decrease it even faster on the way down. Don’t even think about it!
Trade Smart
A smarter and better way to build a pyramid is to wait for new entry setups to materialize in a market that you already have a position in. In other words, you trade the market’s price structure. This is not about calculating how much it takes to finance the next contract; it’s about waiting for the market to show you when and where to add to your position.
A very simple way to implement this is to trail the protective sell stops below each reaction low after a new high for the move is made.
You can also use the new high of the move as an entry signal for more contracts and place the protective sell stops below that same reaction low where the other stops are set. That way, you’ve reduced you risk on all previously purchased contracts and you have a well-defined price structure pattern to add more.
The inverse works for short sales, of course. After a market bounces and then hits a new low for the move, protective buy stops can be relocated to just above the bounce high and more contracts can be sold short.
There are two important rules you should adhere to:
First, only take new setups if the current position has an open profit. You should never add to a position that’s currently a loser. Even a breakeven trade has not earned the right to get bigger yet.
Second, wait until the initial protective stop has been moved enough to significantly reduce or even eliminate the initial risk on the trade.
That’s it. Very simple to understand, very simple to and implement. This is the KISS principle at its best.
Test Drive
As an example of pyramiding with market structure, let’s look at how this might have been applied to a short sale campaign trade in the July 2017 cocoa futures contract. Keep in mind that one contract controls 10 metric tonnes of cocoa, so each tick ($1) is worth $10.
Also, let’s assume an account size of $100k where we’re behaving like reasonable traders and risking just one and a half percent (1.5%) of our equity per trade. None of that crazy “pyramid-your-$10k-into-$1-million-in-two-months” garbage going on here.
We will cap the risk at $1,500 (that’s 1.5% of $100k) so that no losing trade or string of losers can ruin the account or take us out of the game.
Now, there are some who will say that you can’t make any real money when you’re risking such a small amount. Like the saying goes, “No guts, no glory”, right?
Not when it comes to risk management and pyramiding. Just watch and learn.
July cocoa made a double top last summer between the July and August highs of $3,077 and $3,069. The lowest point between these two lows was the July 29th low of $2,800. When this low was broken on September 9th, I think most technicians will agree that a short position could have been entered.
The initial protective buy stop order for this trade could be placed above the double top high of $3,077 or it could be placed above the bounce high that preceded the break at the September 7th six-session high of $2,907.
To keep things simple and low risk, let’s assume a short sale was initiated at $2,790 (ten ticks below the July 29th low) and the initial protective buy stop order was placed at $2,917 (ten ticks above the September 7th high). This sets the initial risk on the trade at $1,270 per contract, which is a bit under our $1,500 risk target.
So here’s a price structure pyramiding plan that could have been implemented:
1 Once cocoa has bounced to at least a five-session high (this would be a one-week high since there are five trading days in a week) and then drops to a new low for the move, lower the protective buy stop for all contracts to ten ticks above the bounce high.
2 *After the protective buy stops on the prior contracts have been lowered, short another cocoa contract ten ticks below the most recent low for the move and place the initial protective buy stop ten ticks above the bounce high as well.
*There is a risk management contingency for the pyramided contracts: it can only be done as long as the total risk on all the prior positions are equal to or less than the initial risk on the trade and the new stop placement eliminates 50% or more of the open risk on the most recent contract added.
Here’s how the cocoa short sale campaign trade may have worked out:
September 19, 2016 – July cocoa rallies to a six-session high of $2,849.
September 29, 2016 – July cocoa drops to a one and a half year low of $2,693, breaking the prior low for the move at $2,729. The protective stop on the initial short contract is lowered to $2,901 (ten ticks above the recent bounce high). The risk is reduced to $1,110, which is not enough to allow for a new short contract. Remember, the new protective stop placement has to cut at least half of the open risk on the most recent contract.
November 3, 2016 – July cocoa rallies to a nearly three-week high of $2,661.
November 4, 2016 – July cocoa drops to a three-year low of $2,539, breaking the prior low for the move at $2,585. The protective stop on the initial short contract is lowered to $2,671 (ten ticks above the recent bounce high). The initial contract entered at $2,790 now has a profit of +$1,190 locked in.
Also, a second contract is sold short at $2,575 (ten ticks below the most recent low for the move) and the initial protective buy stop for this contract is also set at $2,671 (ten ticks above the recent bounce high). The initial risk on the second contract is $960. Cumulatively, this locks in a net profit of +$230 on the entire trade.
November 21, 2016 – July cocoa rallies to a five-session high of $2,447.
December 2, 2016 – July cocoa drops to a new multi-year low of $2,334, breaking the prior low for the move at $2,363. The protective stop on both short contracts is lowered to $2,457 (ten ticks above the recent bounce high). The initial contract entered at $2,790 now has a profit of +$3,330 locked in and the second contract entered at $2,575 now has a profit of +$1,180 locked in.
Also, a third contract is sold short at $2,353 (ten ticks below the most recent low for the move) and the initial protective buy stop for this contract is also set at $2,457 (ten ticks above the recent bounce high). The initial risk on the third contract is $1,040. Cumulatively, this locks in a net profit of +$3,470 on the entire trade.
January 5, 2017 – July cocoa rallies to a six-session high of $2,244.
January 11, 2017 – July cocoa drops to a new multi-year low of $2,103, breaking the prior low for the move at $2,108. The protective stop on all three short contracts is lowered to $2,280 (ten ticks above the recent bounce high). The initial contract entered at $2,790 now has a profit of +$5,100 locked in, the second contract entered at $2,575 now has a profit of +$2,950 locked in, and the third contract entered at $2,353 now has a profit of +$730 locked in.
Note that a fourth contract was not sold short. This is because the prior low for the move at $2,108 was not broken by at least ten ticks.
January 17, 2017 – July cocoa rallies to a six-session high of $2,240.
January 27, 2017 – July cocoa drops to a new multi-year low of $2,100, breaking the prior low for the move at $2,103. The protective stop on all three short contracts is lowered to $2,257 (ten ticks above the recent bounce high). The initial contract entered at $2,790 now has a profit of +$5,330 locked in, the second contract entered at $2,575 now has a profit of +$3,180 locked in, and the third contract entered at $2,353 now has a profit of +$960 locked in.
Once again, a fourth contract was not sold short because the prior low for the move at $2,103 was not broken by at least ten ticks.
January 30, 2017 – July cocoa drops to a new multi-year low of $2,088, breaking the prior low for the move at $2,103. Therefore, a fourth contract is sold short at $2,093 (ten ticks below the most recent low for the move) and the initial protective buy stop for this contract is set at the same place as the others at $2,257 (ten ticks above the recent bounce high). The initial risk on the fourth contract is $1,640. Cumulatively, this locks in a net profit of +$7,830 on the entire trade.
February 16, 2017 – July cocoa rallies to a seven-session high of $2,060.
March 1, 2017 – July cocoa drops to a more than five-year low of $1,899, breaking the prior low for the move at $1,901. The protective stop on all four short contracts is lowered to $2,075 (ten ticks above the recent bounce high). The initial contract entered at $2,790 now has a profit of +$7,150 locked in, the second contract entered at $2,575 now has a profit of +$5,000 locked in, the third contract entered at $2,353 now has a profit of +$2,780 locked in, and the fourth contract entered at $2,093 now has a profit of +$180 locked in.
A fifth contract was not sold short. This is because the prior low for the move at $1,901 was not broken by at least ten ticks.
March 2, 2017 – July cocoa drops to an eight and a half year low of $1,879, breaking the prior low for the move at $1,901. Therefore, a fifth contract is sold short at $1,891 (ten ticks below the most recent low for the move) and the initial protective buy stop for this contract is set at the same place as the others at $2,075 (ten ticks above the recent bounce high). The initial risk on the fifth contract is $1,840. Cumulatively, this locks in a net profit of +$13,270 on the entire trade.
March 13, 2017 – July cocoa rallies to an eleven-session high of $2,023.
March 15, 2017 – July cocoa rallies to a multi-week high of $2,081. This triggers the buy stop orders on all contracts at $2,075 and liquidates the entire position with a net profit of +$13,270 on the trade.
Price Structure Pyramid Performance
So how did this more conservative price structure pyramiding strategy affect the reward-to-risk ratio on the cocoa trade?
Well, the initial trade was entered at $2,790 with a risk of $1,270 per contract and the profit was +$7,150. The profit was a little over five and a half times the initial risk, yielding a reward-to-risk of 5.6:1.
But…
The total profit on the trade was +$13,270 and the pyramiding and risk management rules made it so that the cumulative risk never exceeded the initial risk as more contracts were added. That means the total trade risk was never more than the initial risk of $1,270.
So the +$13,270 profit was nearly ten and a half times the initial and maximum risk on the trade, yielding a reward-to-risk ratio of almost 10.5:1 in the $100k account. That’s nearly double what the non-pyramided trade would have returned.
Consider the fact that the trade initially risked 1.27% and made a +13.27% return in six months without being hyper-aggressive.
Annualized, that’s a +26.54% return on the entire account with a single trade that risked about one and one-quarter of a percent.
Yes, Virginia, there really is a way to make good money on small risks!
Obviously, this cocoa pyramid trade is one of those best case scenarios. They don’t all have this sort of outcome. Most trades don’t. But the example does show you the possibilities of what can happen when you take advantage of a sustained trend by pyramiding the smart way.
Many Ways to Win
In trading, there are many different paths to success. Different timeframes, different setups, different entry signals, different kinds of systems, etc.
The same goes for pyramiding.
In this post, we discussed a wrong way to pyramid and one smart way to pyramid.
But this merely scratches the surface.
In the next post on the subject, we will discuss how volatility can be used for pyramiding. I will also show you a different way to use price structure to build a pyramid. Both of these pyramiding methods can be implemented in a systematic, rule-based manner. So if you’re interested in learning how to potentially turning a single hit into a grand slam home run, stay tuned!
More Articles by Jason Pearce:
How Much Leverage is Appropriate in Your Account?
US Dollar: The New Bear Market?
Equities: US Against the World
Profiting From Failure: The Wash & Rinse Trade, Part II
Profiting From Failure: The Wash & Rinse Trade, Part I
How to Trade with Moving Averages, Part II
How to Trade with Moving Averages, Part I
Market Returns Do Not Equal Investment Returns with Leveraged ETFs
Is The Canadian Housing Market Bad for Canadian Banks?
2017: The Death Year for Stocks
Potential Bond Market Reversal Ahead
