Apart from the possibility of opening a position and leaving it that way until it is closed in profit or loss, there are two possible ways of building a position:
1) Average in
You open the position at some point, but if the price goes against you – and the reasons for your expectation about the price moving in the expected direction haven’t changed – you add to your position, so you better your average opening price.
Your initial position proved itself good, i.e. the price went in your expected direction, and while you are in profit already, you add to your position.
The rule of pyramiding tells that you have to add ever decreasing amounts to the original size, for example like this: open 3 lots, then add 2, then add 1.
This way you can push those positions that proved to be winners, while you lose smaller amounts on those that proved to be wrong.
Do you use any of these techniques?
Please elaborate on when you use one or the other, or a combination of the two; and the details what we should be aware of while applying these methods.
- Average In: This technique can be used in any financial instruments and any time fame – so long as when you initially put on a trade, it is some fraction of your desired full exposure/ full risk, and you have some reason for why you think the price is going to move in your desired direction. So perhaps you throw on 1/3 of the full position size you desire at a certain price. It moves against you, but you still believe in the trade, but not just believe in it, but believe in it more because perhaps you see something in the scenarios/expectations to signal you to start putting on more exposure.
As a simple example, let’s say someone was short EUR/USD around 1.3700 in 2014, but the price was chopping, etc, and the price rises to above 1.3900, but they still believe EUR/USD will go down and they believe that the higher it goes, the more unsustainable the high EUR is, due to expected rate cuts and/or QE by the ECB, and/or the US emerges from the severe winter in 2014 for a more stronger economy. So in this case, the trader can start shorting more EUR/USD, towards more of their full exposure that they want.
You have to take into account that the more you average in when the market is moving against you, the tighter your stop is going to be, since more movements against you will cause more losses.
Another thing to note, you don’t have to have the market moving in your favor or against you to increase your position from a low level. The trade can be around breaking even and you may see something that causes you to add more to it. As a simple example, let’s say the EUR/CHF removal of the 1.20 support. Someone may have been short at 1.2000 from December, but the price isn’t moving in their favor, but they believed with the ECB QE, there is a higher probability of the trade working out, even though the price was still at 1.2000. So they could have added more to EUR/CHF short positions even though the price was the same. Because they believed the macro imbalance in the battle of scenarios was growing and would have to be resolved.
I usually only use this strategy in the equity market when I am looking for stocks to buy. Usually if I believe the bull market will continue, and I find a nice company/industry scenario that will cause a stock to move, then I may buy in a small position, and if it moves against me, and I still like the trade and the stock is a bargain as the value buyers and scenario that I expect buyers to come back to raise the price.
For example, last year, I was long AAPL from 2013. I got my full position and desired exposure of around 10-20% of my equity right away. So when AAPL dropped -10% in a day in 2014 or so, I didn’t add more exposure because I was already at maximum exposure I desired. But I kept it all because I still believed it was a bargain and the market would realize it’s value and the share buybacks helping to reduce losses, etc. I did tell the trade to some of my friends who did buy more on that drop.
I was also long EBAY with a smaller position say 3-4% of equity around $52 or so I believe. And it went against me, but I doubled up on it around $50 because I still believed in the bull market and company scenario of unlocking value in PayPal, etc. In the end the price did rise to $60, though I got out before then. It also tripped stops below $49/$48 before running up to $60, so someone could have bought more or initiated a new position there.
- Pyramid: The pyramid you can use in any time frame and instrument. This is when you have a trade that is going in your favor, and you realize it is a nice trade, and can have even more momentum in your favor, but you realize that perhaps your initial position was a bit too small. You realize that if you keep the same position, it will not make a meaningful contribution to the profits, because the position size was very small. So you add to the position, not just because it has moved in your favor, but you believe it will continue to move in your favor in a dramatic way, sometime soon – like next few days or weeks.
This all requires a thorough understanding of the macro situation and battle of scenarios, etc. So you can know when the market can snap back in your favor for averaging in, and when the market can continue moving in your favor for pyramiding. You don’t want to get caught buying top tick or shorting bottom tick of the move and suffering from macro scenario exhaustion, etc. So it takes continued practice of the universal principles of speculation in my opinion, then you can add in this averaging in and pyramiding in.
Stanley Druckenmiller from The New Market Wizards said: “The few times that Soros has ever criticized me was when I was really right on a market, and didn’t maximize the opportunity.”
Druckenmiller also tells a story of how he was short the dollar against the Deutchemark with around $1 billion dollar position. Which I believe was around 50% of the fund equity. The trade moved in his favor, but Soros told him “you call that a position.” So that comment, combined with Druckenmiller’s conviction that the trade would continue to move in his favor (conviction meaning his read of market conditions), convinced him to double the position to double the position to $2 billion or so, and the trade did keep going in his favor.