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Building Pyramids for Asymmetric Trading Gains Part 2

Jason Pearce

Jason Pearce

Jason Pearce is a 25+ year veteran of the futures markets. Since 1991, he has played the roles of retail broker and managing director of a brokerage firm, trader, market analyst, newsletter writer/editor and trading systems/algorithms developer. Jason is now actively managing money as an independent RIA.
Jason Pearce

By Jason Pearce

Full Court Press

In a prior post, we discussed the topic of pyramiding.  This is where you take advantage of a winning trade by continually adding more and contracts or shares as a market trends in your favor.  The objective is to increase the size of your winning trades without a substantial increase in the risk on the trade.

First, we discussed an aggressive strategy of adding futures contracts just as soon as the open profits on a trade provide enough financing to do so.

Most traders initially learn about pyramiding this way.  As a matter of fact, I can recall a trading book that I read as a teenager that taught how to turn a $5,000 grubstake into $250,000 by simply following this easy path to “unlimited riches” while working a mere 15-20 minutes a day.

This is the absolute worst possible way to go about it.  It nearly always ends in tears.  The post explains why and shows a vivid example.

Next, a more sensible method was demonstrated.  This pyramiding method relies on the market’s price structure to determine where and when to pyramid a position.  There’s a delicate balance between pursuing profits and managing risks.  If you want to trade like a professional, this is the way to go.

In this post, we are going to touch on a couple of the more lesser-known pyramiding techniques.  These ideas will give you more options to work with.  This allows you to find and customize the pyramiding method that best suits your personal trading style.

Turtles, Pyramids, and Volatility

In full disclosure, what I know about Richard Dennis’ famous group of Turtles is only second-hand and third-hand knowledge.  When the Turtles were busy building their trading fortunes in the early 80s, I was busy doing my schoolwork, riding a BMX bike, and listening to my Def Leppard and Van Halen cassette tapes.

That being said, several of Dennis’ protégés have shared the secret sauce of the trading system that he taught them.  I feel like there’s enough information out there now that I can relay and comment on it.

The Turtles used volatility to determine their position sizes.  More fitting to out topic of discussion, they also used volatility to determine where they would add to their positions (i.e. pyramid).

They measured market volatility via the Average True Range (ATR), which is a tool that many professional traders still utilize today.  Specifically, they used the 20-day exponential moving average of the True Range as their volatility yardstick.

Once the Turtles bought a market on a breakout above a 20 or 55-day high, they would place their initial protective stops and then place order to buy more contracts at progressively higher prices.  These pyramid orders were designed to ramp the position size up as quickly as possible.

The 20-day ATR that they measured volatility with was referred to as “N”.  To pyramid, the Turtles would add to their long positions in intervals of ½ N higher as the market moved up.  So if the 20-day ATR of a particular market is 160 points, then ½ N is 80 points.

Importantly, the intervals were based on the actual fill prices.  So they would buy another round of contracts 80 points (½ N) higher than the last fill price.

The amount of entry points that a Turtle could take on one particular market was limited to four.  So after the initial breakout purchase was made (entry point #1), the position could be pyramided up to three more times at entry points #2, #3, and #4.

The protective sell stop for the contracts bought on the initial breakout was set at 2N below the entry price.  Also, the protective sell stop for each pyramided position was set at 2N below the entry price.  The thinking behind this is that the stop would be out of the way of random market swings since it’s double the average volatility of the last one month of trading (there’s typically twenty trading days in one month).

For example, if the 20-day ATR of a particular market is 160 points, then 2N is 320 points.  So the initial protective sell stop was place 320 points (2N) below the entry fill price.

Most of the time, when a new entry point was made, the protective sell stops on all units were raised to 2N below the most recent entry price as well.  The Turtles had a couple alternatives to this, but this was the standard method they used.

So there you have it: the pyramiding technique used by one of most famous and profitable trading group in the world.

Turtle Troubles

Before you take this Turtle pyramiding idea and apply it to your trading, there are a couple of potential drawbacks you should take into account.

First, recognize that the risk on the trade actually increases as more contracts are added.  Risk does not stay static or decrease the way that it does with the methodology we discussed in the prior post on using price structure to pyramid.

Suppose the 20-day ATR for gold is $13.00 and you went long a single 100/oz. futures contract at $1,240.00.  With the Turtle method, the initial protective sell stop would be set 2N or $26.00 below the entry price at $1,214.00.  This sets the initial risk at $2,600 on the trade.

If gold rallies ½ N higher ($6.50) you would purchase a second contract at $1,246.50.  The initial protective sell stop for this first pyramided contract would be set 2N ($26.00) below the entry price at $1,220.50.  Additionally, the protective sell stop for the initial purchase would also be raised to $1,220.50.

Here’s the rub: The risk on the pyramided contract is initially $2,600.  The risk on the initial contract, although reduced, is still $1,950.  So the total risk on the trade has now increased to $4,550.

Once you’ve extrapolated this out to the Turtle’s maximum position size of four entry points on the trade (the initial entry and three more pyramided entries), the total trade risk has jumped to $6,500.

That’s two and a half times the initial risk on the trade.

See the problem here?

Like I said, this is a potential drawback.  It doesn’t have to definitely be one.

If you know beforehand that the trade risk will increase as the pyramid is built, you could elect to initiate the trade with just a fraction of your maximum risk-per-trade.  Then as more contracts are added via the pyramid rules, your trade risk gets closer to your maximum risk-per-trade levels and finally reaches it when the last entry point is triggered.

In other words, you put a toe in the water and build up to your targeted maximum risk-per-trade as the market proves itself.  There’s certainly nothing wrong with a strategy of scaling into a position.  Many smart and successful traders do this.

A second potential drawback to this strategy is that the initial entry order and all three of the pyramid buy orders can get elected and filled all on the same day.

Worse yet, they could all be entered and then liquidated on the very same day!

If you’ve been trading for even a short length of time, you may have seen or even been caught in one of those “long bar” market spikes on the charts where prices rocket higher.  These sorts of moves happen on the downside as well.

As a matter of fact, the downside spikes seem to be more severe.  Anyone remember the Flash Crash?

One way you could offset this risk is to modify the pyramiding rules and limit it to one entry point per session.  That way, you will never be full loaded and then knocked right back out all in one fell swoop.

However, there is a potential downside to implementing a time limit rule like this.  If a market spike happens to be the start of a parabolic runaway move, you could miss significant chunks of the move and/or not get all the contracts you want.

There’s a tradeoff with everything in life, though.  You have to determine what is best for your own emotional makeup and capital risk.

Climbing Ladders

Now I’m going to show you a different twist on how to pyramid by incorporating both price structure and volatility.  I call this strategy a price interval ladder.  This is a method I’ve used many times, particularly with spread trade positions where I only track the closing prices, to build small positions into large positions.

You need to know up front that this pyramiding strategy is not something that I feel is compatible with a day trading or swing trading system.  (Why in the world are you day trading anyway?!)  This strategy is to be used in a campaign trade where you want to ride the trend for as long and as far as it will carry you.

In a nutshell, price interval ladders are evenly-spaced price points that are set in a market where contracts will be entered at progressively higher levels as the market advances.  Think of it as climbing a ladder and each higher price point interval is like a rung on that ladder.

The same set points of these price intervals are also where the protective sell stop levels will be trailed “up the ladder” until the market finally reverses trend and all contracts are liquidated.

Although the price interval ladders are based on price structure, it’s a different application than where we discussed trailing protective stops and adding after the market reactions against the trend.

Instead, we will measure the sizes of the countertrend moves in a trend.  Then the entry and exit points are set in price intervals that are larger than the size of the preceding countertrend moves.

The objective in spacing the intervals is to make them wide enough to be able to withstand any countertrend moves that are similar in size to what has already been occurring.

High-Tech Ladder

Let’s look at the NASDAQ 100 futures contract for an example of how a price interval ladder could have been applied during this run over the last few months.

In September and October of 2016, the NASDAQ 100 futures market prodded and poked at the 4,900 level a couple of times and stayed stuck in a trading range.

The election happened on November 8th and stock futures went absolutely nuts.  First it plunged to multi-month lows and then it rocketed back up to the highest level in several days.  The pullback from the preceding high in the all-session high was as much as 361 points.

At the end of the month, volatility had settled down.  The NASDAQ 100 had once again neared the 4,900 level and backed off one more time.

This time, the pullback was about 196.25 points in size.  This was larger than the 147-point pullback that the market experienced off the early October high, but not too different from the 207.75-point pullback that the market experienced off the August high.

In mid-December, the NASDAQ 100 finally cleared the 4,900 barrier.  With a breakout above the trading range and new all-time highs, anyone who looks at charts has to be bullish.  Therefore, let’s assume that a trader will want to get long.

We’ll be patient and wait for a bit of a pullback before jumping in.

The pullback finally occurred at the end of December when the market retraced 144.50 points from the December 27 record high of 4994.50.  Therefore, we can put in an order to buy a breakout to 5005.

Now let’s build a price interval ladder!

Due to the unusual volatility surrounding the election, we are going to disregard the pullback that occurred at that time.

With that in mind, the pullbacks that preceded the breakout ranged in size from 144.50 points to 207.75 points.  Therefore, we are going to set an interval ladder of 210 points to trade the NASDAQ 100.

This means that once the buy stop order at 5005 is filled, a protective sell stop will be placed at 4795.  Also, additional buy stop orders will be placed every 210 points higher at 5215, 5425, 5635, 5845, etc.

Every time a buy stop order is filled, the protective sell stop orders for all contracts will be placed 210 points lower than the most recent entry, which is one “rung” lower on the price interval ladder.  This process will carry on until the entire position is liquidated either by a sell stop getting triggered or a profit objective being met.

Here’s how this strategy would have worked out in 2017:

January 6, 2017 – NASDAQ 100 rallies to 5005 and fills buy stop order.  A protective sell stop order is placed 210 points lower at 4795 and a buy stop order to buy more is placed 210 points higher at 5215.

February 9, 2017 – NASDAQ 100 rallies to 5215 and fills buy stop order.  A protective sell stop order is placed 210 points lower at 5005 for both long contracts and a buy stop order to buy more is placed 210 points higher at 5425.

March 15, 2017 – NASDAQ 100 rallies to 5425 and fills buy stop order.  A protective sell stop order is placed 210 points lower at 5215 for all three long contracts and a buy stop order to buy more is placed 210 points higher at 5635.

May 1, 2017 – NASDAQ 100 rallies to 5635 and fills buy stop order.  A protective sell stop order is placed 210 points lower at 5425 for all four long contracts and a buy stop order to buy more is placed 210 points higher at 5845.

June 2, 2017 – NASDAQ 100 rallies to 5845 and fills buy stop order.  A protective sell stop order is placed 210 points lower at 5635 for all five long contracts and a buy stop order to buy more is placed 210 points higher at 6055.

June 12, 2017 – NASDAQ 100 declines to 5635 and elects the protective sell stop orders for all five contracts.  The trade results in a profit of 1,050 points, which is a 5-to-1 return on the initial risk.

The beauty of measuring the sizes of the countertrend moves in a particular trend is that it is relative to the current market conditions.  It works just as easily in currencies…and crude oil…and grains…and bonds…and any other market you can think of.  This is a robust strategy.

Ladder Modifications

Once you get the hang of this price interval ladder strategy, there are a couple of ways that a trader could build a better mousetrap and modify it.

First, the trailing exit stop or “lower rung” on the ladder can be trailed as the market makes new highs for the move without having to wait for the higher pyramid entry orders to get elected first.

Since the size of the countertrend moves off the highs were measured and the price intervals were placed in increments that are larger than the typical reaction, this is a smart trailing stop strategy that works to reduce risk at a faster pace.

Another modification is to update the size of the price intervals based on the most recent couple of countertrend moves.  If the pullbacks are getting bigger, the wider price intervals will provide more breathing room.

Conversely, if the pullbacks are getting smaller, the tightening price intervals will reflect that and reduce the risk on the trade.  This can have the positive effect of increasing the reward-to-risk ratio on a trade.

Know Your Limits

Do some noodling on these pyramiding ideas and figure out what sort of strategy makes the most sense to you and what gels with your own trading system/methodology.  Once you’ve decided on what you’re going to do, though, you’re homework isn’t complete.

You will still need to determine just how big you’re willing to build your pyramids.

Even though you’re trailing the protective stops as you pyramid a winning position, you still need to set a limit on how big you will go.  This is because there is no iron-clad guarantee that your protective stops will be executed and filled at the exact price of your order.  Price slippage –especially after a big run- tends to be the norm.

I’ve seen a reversal in the silver market only take twenty minutes to destroy one-third of a profit on a trade that took weeks of pyramiding to build…and that wasn’t even the final top for the market!  Traders beware.

Nasty slippage is not even the worst thing that can happen.

If a market suddenly makes a limit move against you, there’s no guarantee that your stop order will even be executed at all!  You could be stuck in a lock limit situation for days at a time.

This lock limit scenario is a worst case scenario.  It rarely happens.

But the fact that it’s possible means that you have to build it into your contingency plan.

It only takes one of those to put a trader out of business if the leverage is too high.  You’ve heard the story of what happened to those geniuses who ran Long Term Capital Management, haven’t you?  It was the leverage that killed ‘em, not their being wrong about the market.

So if you’re going to build pyramids, make sure they aren’t big enough to crush you when they occasionally topple over.


More Articles by Jason Pearce:

Building Pyramids for Asymmetric Trading Gains Part I

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

 

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