Tuesday, August 01, 2006

Breaking Off A Piece: Part 1

Here's the blueprint for one of the more interesting basic pyramidding campaigns that you can do in a stock. This is nothing original, I'm just throwing it out there for discussion because it is useful and the numbers work out nicer than many of the other variations.

The strategy can be used when two conditions exist: a) the stock is strongly trending up, and b) you want to own shares. For your campaign, you must identify up front the amount of "risk capital" for your operation. If your campaign is successful, you will have a block of stock, and have converted all of your "risk capital" back to cash for use in the next campaign.

Say we want to break off a $5k block of stock. For this specific campaign you will need 3 times that amount in risk capital, so $15k. After carefully identifying a good risk:reward entry point using your favorite technical analysis or tape reading, 1/3 of the risk capital ($5k) is committed.

If the stock moves in your favor 10%, commit another 1/3 of the risk capital ($5k). You will have committed $10k of risk capital and are carrying $10,500 of stock.

After the position moves in your favor another 10%, commit the final 1/3 of your risk capital. You will have committed the full $15k of risk capital and are carrying $16,550 of stock.

A limit order is placed to sell 3/4 of your shares 21% higher than your final entry. After the stock has advanced 21% from your final entry point, your position will be worth $20,025.50. If your limit order fills completely, you will have reclaimed your entire $15k of risk capital, and have a $5k block of stock.

At no point are you excessively exposing your capital to great risk. As the position moves in your favor, you will gradually be enabled to reclaim most or all of your risk capital if you stop out. If the position moves against you from the start, you will only take a loss out of 1/3 of your risk capital. What you have done is taken shares from people who are not managing the risk as well as you are. By managing risk in ways similar to this, a trader can break off quite a lot of stock over the years.

Here's a spreadsheet recap of the strategy:

Risk capitalPercentage multiplierPosition size

These numbers are just used as an example, there are all kinds of variations that can be used in different scenarios. A variation of this strategy can even be adapted for use by market makers to build inventory by adjusting the percentages way down.


At 9:01 AM, Anonymous Anonymous said...

"At no point are you excessively exposing your capital to great risk." That is an extremely invalid statement based on things working out exactly as planned. At no point does the market care how you have chosen to enter your position. Just stop for a moment and think about what would happen if the market had a sharp pullback right after you add the complete 15K. How much risk do you have then? Well, 3 times the risk of the initial position. Risk has nothing to do with the method of entering but simply with how much money you have in a trade and how big your stop is (and even that isn't guaranteed). Pyramiding is not risk management but simply momentum trading. Your risk is actually increasing first, then decreasing as you take money off. It's a pure and simple function of the amount of money you put in the market unless you know what the probability of the stock moving down is. And if you know that then you are way ahead of the game. But I doubt you do in this scenario.

At 11:09 AM, Blogger jontait said...

You didn't follow along properly. I'll quote you:

"If the market had a sharp pullback right after you add the complete 15k... Well 3 times the risk of the initial position..."

No. Here's why, the capitalization of your position at that point is $16,500, a $1,500 cushion (10% cushion) before your risk capital even takes a knick. You said it yourself, risk is how much of your money you risk losing on a trade:

"(Risk) is a pure and simple function of the amount of money you put in the market..."

Of course your risk in the event of a liquidity type of crisis is higher, but it goes to ZERO the moment you get your risk capital out of there. The market is an odds game, which is the point of my post. A liquidity crisis isn't going to happen every time you do a campaign like this, so play the odds and break off as many pieces as you can. There are good times to bet that a liquidity crisis isn't going to happen.

At 2:18 PM, Anonymous Anonymous said...

Great post - and you're right, this is a great way to scale into a trade. In a similar manner, when a position moves in your favor, and your technicals tell you it's okay to adjust your stop at or above your entry - your capital is protected, and you could then add to your position (should your technicals tell you it's reasonable to do so). Then, only your new batch of shares are at risk, and so forth.

R in Texas

At 7:05 PM, Blogger Declan Fallon said...

Hi Jon,

Is this strategy what you use yourself? Are these share blocks 'held' indefinitely, or sold after an additional fixed gain (eg. 21%)?
Just curious.


At 8:56 PM, Blogger jontait said...

I use this technique in very specific situations, it resembles a cork screw more than a swiss army knife. I'll be posting a few more variations that are also very specific and useful in completely different situations.

I am currently using this strategy on a stock. After the final target has been reached and my risk capital has been recovered, I will trend follow with the remaining shares. In this case, there is no dividend, but if there is, you can simply collect the dividend indefinetely and borrow margin against the position.

At 1:25 AM, Anonymous Anatole said...

This pyramiding technique actually hurts your return if the stock moves in your direction and does little in the way of risk management. On the other hand, if you sized your position correctly in the beginning based on risk you benefit from the entire move and are only risking what your money management system allows for.

At 12:02 PM, Blogger jontait said...

When all you have is a hammer, everything looks like a nail. Likewise, if a simple "one money management scheme fits all" is all you can concieve trading with, I can't possibly offer you anything useful. Maybe you'd rather I post stock picks in this environment?

You really can't think of any scenarios where it would be useful to transfer risk to parties who are willing to take it in order to make a 46% gain out of a move instead of 33%? How about when you are position trading on 40% to 50% margin? Or when your expected highest point of failure is at the initial entry point?


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