Pyramiding a position in the stock market simply involves adding on to an existing profitable position. This technique is totally opposite to averaging down into a loss-making position. As the stock/instrument, in which position has already been made, performs in the predicted direction, more shares are added so as to reap more gains. Building position in this way enhances the probability of increasing profits as the stock resumes its trend.

Four Phases of The Market

Before getting directly into pyramiding, it’s important to discuss about the market phases. A market structure comprises four phases, namely accumulation; markup; distribution; and markdown as shown in the figure.

The accumulation phase starts after a prolonged markdown phase. In simple words, this phase begins when institutional participants find the market undervalued and are attracted to invest in the market. Their huge funds provide support to the market and absorb all the available supply. The price action in this phase is volatile but often restricts to well-defined boundaries also known as Range.

The markup phase begins as the stock breaks out of the bottom range formation or accumulation. The breakout attracts more investors and many other medium to short term traders, which fuels the price in an impulsive fashion. Normally we see heightened volatility at the end of this phase with widening daily ranges, signaling greed entering into the market. Valuations would skyrocket at this stage but new entrants would least care about it.

The institutions who accumulated at the bottom take advantage of those greedy buy orders and start booking profits at higher prices. This phase is called distribution. It may take a few weeks or sometimes a few months before the distribution is over. This phase traps most of the retail traders into false breakouts at the top.

Now that the institutions have liquidated most of their positions, there is not much support left in the market. It leads to the fourth phase that is, markdown. Weak retail holders also start liquidating their positions in panic which further fuels the downtrend. This phase also ends with heightened volatility and wide daily ranges, which reflect fear among traders and hence another opportunity for institutions to accumulate.

Pyramiding and Market Phases

Now that we know the market phases it becomes easier for us to understand pyramiding. There have been some general misconceptions among traders regarding pyramiding. Firstly, they take a very small initial position and then increase their position sizes in multiples. As an example, if they are to buy 600 shares of a company, they would first buy 100 shares. Then as the trade progresses in their favor they would like to add 200 and then 300 more. It would not be wrong to call this reverse pyramiding. Because we have a smaller base and heavier top. The approach discussed in the article contrasts with this type of pyramiding.

The second misconception has been to buy the breakouts to add into an existing position, irrespective of the fact that most breakouts fail. In simple words, if we position into a reverse pyramid as discussed in the above example and buy the breakouts, we will make a top-heavy position which has higher chances of getting into a loss in the event of even a minor pullback. So, what is the correct approach?

We all know the shape of a pyramid. In a two-dimensional figure, it just looks like a triangle. They are wider at the base and narrower at the top. When it comes to Pyramiding in trading, it should be no different from a real pyramid. Our initial position should be relatively heavy near the wide base. Consider the base as an area of accumulation which has been discussed in the previous section. At least 50% position should be taken at or near the base. This will reduce the risk on a position by half compared to taking a full position at once.

As the trade progresses in our direction, more shares can be added in two parts. The first part will be 33% and the second 17% as shown in the figure. Both these positions can be taken in the second phase of the market, which is the markup phase. Adding in this phase may enhance our profits as we already know the trend and are confident due to larger position at the base, which is already in profit.

The above figure demonstrates a short position that can be initiated during the third phase, that is distribution phase, and increased in the markdown phase of the market. For this, experienced traders use bearish trading strategies in futures and options.

An Efficient Way to Add Positions

We all know that majority of the breakout fail in the markets. And secondly, the risk involved in a breakout trade is usually high due to wider stop loss. So, it is not advisable to always buy the breakouts, for adding into a position, as the stock is making new highs. There is rather a more efficient technique, that is to buy the pullbacks. This would not only increase our profit potential but also reduces the risk on our top-up positions.

Markets have a general tendency to pause or take a rest after strong moves. This may drift the price within a range or may drag it down to a prior resistance zone, which had been taken out during strong breakouts. The best places for pyramiding would be the bottom of the range, and at the prior resistance zones or retests (see example section for more).

It is important to wait for the price to first take support at these levels. One should wait for some bullish candlestick pattern and then hit the buy button.

One may also use various techniques such as price action patterns or technical indicators to identify and confirm potential reversals so as to add the remaining 33% and 17% positions at the end of pullbacks shown in the figure above.

Let’s Take an Example

The following example of Eicher Motors daily chart represents all the four phases of the market as the market turns from bullish to bearish and then from bearish to bullish.

The stock developed a highly volatile range at the bottom. This is the accumulation phase. This phase may vary in size as well as shape in different stocks/instruments. Normally you would observe swift breakouts after an accumulation phase is over. This is the only place where we can afford to take a breakout trade because the success rate is higher for such breakouts. One can add a 50% position at this place. The stop loss would go right underneath the lowest low of the accumulation range.

One can add 33% and 17% of the remaining position after the first and second pullback (see chart). These pullbacks may end up as some continuation patterns like flags, pennants or an a-b-c type correction, etc. The investor needs to wait for a bullish reversal sign before adding more shares. The break of a downtrend line will also act as a sign of resumption to the upside (see chart below), and hence an opportunity to add.

As the stock makes a new swing high, the stop loss for the entire position can be brought up. The stop should be kept at a safer place like below the pullback swing lows. This technique is called trailing the stop loss and is very useful to reduce risk or lock-in profits. The entire/partial position can be exited near a previous strong resistance zone (if exists) or at some other measured target.

Fresh Positions in Markup Phase

Initiating a position too late in the markup phase reduces the probability of success, as this may trap the traders right at the top of a rally. But sometimes we may observe a re-accumulation phase (as visible on the above chart) in the middle of a very strong uptrend. This phase attracts more buyers and hence more chances of another strong-up move. You would often observe a strong markup after these re-accumulation zones. Fresh buyers can enter near the bottom end of this re-accumulation range, as the risk involved will be minimum at that point. Top-up positions can also be added after minor pullbacks as described earlier.

Concluding Remarks

The pyramiding technique discussed in this article follows the ‘buy low - sell high’ philosophy. Building a maximum position at lower prices increases profit potential and reduces risk. The technique also respects market cycles and is hence useful for long-term investments. Although this pyramiding strategy is efficient in many aspects yet we need to accept that no strategy is hundred percent foolproof. Therefore, the protection of capital should be the first one on our priority list. For that, one should make use of stop-loss orders. As the trade progresses on expected lines, stop loss can be trailed underneath an important swing low or a re-accumulation zone.

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