Wednesday, March 28, 2012

The Art of Speculation Series 4 - Stock Market Pyramiding




It is everyone’s objective to make money when investing in the stock market. Taking losses will be the last thing they had in mind. So when a stock goes down, they tend to buy more or average down because they believe that when the market rebounds later they are able to make back their losses ‘at one shot’. It is a conventional argument that in stock market investment, anything that is cheap is good and hence the bigger the price drops the more we should buy.

Pyramiding Up


When you have done your homework and analysis, there are two possibilities that may arise when you decided to take the plunge. One, the stocks that you bought moved up and the other is it moved down. The problem is how should you react to both situations? I am sure you would like to increase your profits when your stocks moved up. How can you do it?

There are two ways to increase your profits. One is by trading more frequently during the up trend and the other is by increasing your positions. Trading more frequently will be out of the questions because the commissions and taxes will kill you. The other alternative is to increase the size of your position or in other words leverage up.

Leveraging up or what we call pyramiding up is another strategy that can help you maximize your profits when the market goes up. The question is how much to pyramid up so that it will help you maximize your return and minimize your losses? Basically there are three ways to pyramid up and we shall examine them individually.

Three different scenarios


There will be three different scenarios when pyramiding up.
  1. Buy on decreasing quantity when price go up
  2. Buy on even quantity when price go up
  3. Buy on increasing quantity when price go up

Lets analyze the above scenarios below based on the following assumptions.

  1. total quantity bought is 500 shares
  2. price increase at $1 per interval
  3. shares bought on 5 different time intervals


Chart 1. Buy on decreasing quantity of shares for every dollar increase.

NoPrice QuantityTotal
1
$10
200
$2,000
2
$11
150
$1,650
3
$12
80
$960
4
$13
50
$650
 5
$14
20
$280
Total
500
$5,540


The average price for this purchase is $11.08 ($5,540/500)


Chart 2. Buy even 100 lots for every dollar increase.

NoPrice QuantityTotal
1
$10
100
$1,000
2
$11
100
$1,100
3
$12
100
$1,200
4
$13
100
$1,300
 5
$14
100
$1,400
Total
500
$6,000


The average price for this purchase is $12 ($6,000/500).


Chart 3. Buy on increasing quantity for every dollar increase
 
NoPrice QuantityTotal
1
$10
20
$200
2
$11
50
$550
3
$12
80
$960
4
$13
150
$1950
 5
$14
200
$2800
Total
500
$6,460


The average price for this purchase is $12.92 ($6,460/500).

The Best Strategy when Average Up


As you can see from the above three charts, the lowest cost and best strategy is achieved in Chart 1. Total cost outlay is $5,540 and average cost is $11.08. Chart 3 is the most costly and inefficient strategy with total outlay at $6,460 and average cost is $12.92.

Now, what happen when the market corrects? In normal conditions, when the market corrects it will give back 50% of its gains. In this case, the gain is $14 - $10 = $4 and 50% of $4 is $2. Hence the stock price will retrace back to $12. As you can see, in Chart 3 the average cost is $12.92 and hence this strategy will be making a loss. Chart 2 will be back to square one, however Chart 1 still provides you with a winning strategy.

So, what we can learn here is that when we average up our bets, make sure that the quantity is on a descending scale.

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