In the classic trading book, Reminiscences of a Stock Operator, Jesse Livermore spoke a little bit about a professional gambler called Pat Hearne. Pat would treat the markets like a casino game (such as roulette, faro or blackjack) and his strategy was to make a series of calculated bets, always looking for small, sure wins.
When it came to selling, Pat would close the trade whenever the stock dropped back by just one per cent. Pat didn’t like to take chances and a decline of 1 point was all it took to get Pat out of the market and onto the next opportunity.
This was a sensible approach to trading that also had a big influence on Jesse Livermore. Jesse admired his professional approach to risk and also the candid words of wisdom that the gambler had for other traders:
“Pat Hearne made money in stocks, and that made people ask him for advice. He would never give any. If they asked him point-blank for his opinion about the wisdom of their commitments he used a favourite race-track maxim of his: ‘You can’t tell till you bet’.” — From Reminiscences of a Stock Operator.
You don’t know until you bet
Like Pat Hearne, Jessie realised that you can’t judge a market until you are in it. This is why Jesse would buy a little bit of the market first, to test the water. If the trade felt good, and the stock moved as he liked, he would add a little bit more, gradually building up a bigger and bigger line.
This is how you pyramid into the big trends and make the most amount of money. Price follows the line of least resistance so you simply go with the flow and keep building your position. If you pyramid smartly enough, you truly can make a significant amount of money in just a short time. Just like a colleague of mine did in the oil market.
Of course, pyramiding into a winning position and starting off small is the opposite to what most traders do. Most traders accumulate more shares on the way down, when they’re actually losing money.
They see that their trade is losing money, but they believe that the market is actually becoming cheaper and more attractive. They still believe that they’re right, so they buy more and try and reduce their cost base. This causes them to ‘average losses’ and they end up building a huge losing position that often ends up causing considerable pain.
The market is sending out a signal. It’s saying that it’s not ready to go in that direction, and you can’t force it. But by ignoring the market, and by adding to a losing position, you are fighting the trend and usually causing an imbalance in your risk management rules.
Pyramiding Like Jesse Livermore, the Boy Plunger
Jesse would always accumulate his position on the way up, often trading at brand new highs. He’d start by buying one-fifth of his full line.
If the market did nothing, then he’d wait. If it showed him a loss he’d get out. If it started to go up, he’d assume that he was trading in the right direction and then he’d add another contract. If it went up again, he’d add a bit more, and a bit more, and a bit more, and so on, slowly building up his full position.
This way you bet big only when you win, and when you lose, you only lose a small exploratory bet. Once the real move starts, and the big trend really starts to kick in you can make the large profits extremely quickly and easily.
“What I have told you gives you the essence of my trading system as based on studying the tape. I merely learn the way prices are most probably going to move. I check up my own trading by additional tests, to determine the psychological moment. I do that by watching the way the price acts after I begin” — From Reminiscences of a Stock Operator.
Another approach to pyramiding
As mentioned above, Jesse Livermore liked to start off with his smallest position. This is just one effective way for you to approach pyramiding. Dip your toe into the water and see if it’s warm or cold. If the water is warm and your trade is looking healthy you can think about adding another contract or two.
Another option, which is not necessarily how Jesse used to trade, is to put a big position on first of all, in order to build a sturdy base for the eventual pyramid.
src: AZ Quotes
Then, you add smaller and smaller increments on the way up. This way your position size actually looks more reflective of the classic pyramid shape.
As an example, let’s say you buy $1000 worth of stock when it breaks out past $10 a share. When it moves up to $11, you can buy another $500 worth, then when it moves to $12, you can buy another $250 worth, and when it moves to $13, you can buy another $125 worth. Or, in other words, you buy 100 shares at $10, 50 shares at $11, 25 shares at $12 and so on.
By doing it this way, the position does not become too top heavy. The break-even price is lower than it would be if you’d have bought equal amounts on the way up. This means that you can afford slightly more time when it comes to getting out of a trade.
This might be important. Because, when you pyramid into a position, the trade can become large. And you will want to exit as soon as the trend changes in order to protect your profits. Becoming tied to a pyramid trade is a very dangerous position to be in. But of course, you should know by now to never fall in love with a trade right?
This post is a small excerpt from a new series I am developing that is devoted to the master trader himself, Jesse Livermore.
What are your own thoughts on pyramiding? Do you use it in your own trading? Do you ever take a small position first to test the water?
Please leave your comments and thoughts below, and share this post if you found it useful. 🙂
Thank You For Reading
Joe Marwood is an independent trader and the founder of Decoding Markets. He worked as a professional futures trader and has a passion for investing and building mechanical trading strategies. If you are interested in more quantitative trading strategies, investing ideas and tutorials make sure to check out our program Marwood Research.
This post expresses the opinions of the writer and is for information, entertainment purposes only. Joe Marwood is not a registered financial advisor or certified analyst. The reader agrees to assume all risk resulting from the application of any of the information provided. Past performance is not a reliable indicator of future returns and financial trading is full of risk. Margin trading can lead to losses more than in your account. Mistakes in backtesting and presenting of analysis regularly occur. Please read the Full disclaimer.