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Saturday, March 31, 2012

Pyramiding

A whole back IBD had a column on pyramiding into a position (it was a few weeks ago so I don't remember which date: it may still be on the website under "Education"). One reason I wanted to do a post on it: O'Neil's method is almost the opposite of mine. Here is the basic gist of his method:

1. On the initial buy, buy 50% of your ultimate position (for example, if you allocate $10000 for each position you hold, buy $5000 on the initial buy).
2. If the stock goes up about 2%, buy another 30% ($3000).
3. If it goes up another 2% after that, buy that lst 20% ($2000).

O'Neil's reasoning is simple: as the price goes up, so does risk, so you have the least risk one the first buy, since you are in theory buying a breakout at the proper buy point.  As the stock goes up, risk does as well, so in adding to the position you make smaller buys to minimize the risk. If the stock never moves up, but instead reverses and hits the 8% sell point, you lose 8% of $5000 rather than $10000.


While O'Neil's reasoning does make sense, I'm not so sure that the biggest risk isn't on the initial buy. My normal method of pyramiding into a stock is more like this:

1. the initial buy is no more than 25% of the ultimate position (it can be as low as 10%, depending on the stock's volatility).
2. If it moves up, another 25% is added.
3. If it moves up again, 50% is added. Theoritically I can keep adding to a position that is working, but in practice I have never gotten past step 3.

My reasoning is that if the initial breakout does not fail, the risk of a sudden reversal drops as it goes up (that is not based on research, just a hunch on my part). Another reason for taking bigger positions is commissions: even with a discount broker, commissions still take a bite out of profits (if you are using $10000 as your base position size, it isn't that much of an issue, but my positions are usually quite a bit smaller than that). The later buys don't have to go up as much to make a profit, and usually on breakouts the bulk of the gain is made on the first few days.

Another factor to consider is the type of stocks being traded.While we both try to get leading stocks, O'Neil specializes in "institutional quality" stocks, which means they trade a lot (over a million shares a day). I usually trade stocks that trade under a million shares a day, and frequently I'm trading stocks that trade little more than 100k shares a day. A 2% move in an institutional quality stock is a pretty good size move: in the small caps I trade 2% is nothing.

So, if I was to make a recommendation I would say that O'Neil's method works best for highly liquid stocks, while my system works best for lightly traded volatile issues.

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