Remember the ‘Pyramiding’ lesson from Jesse Livermore I covered in last week’s issue? Well, it’s just about THE best way to build a long term trading position that offers huge potential profits from tiny initial risk.
It’s a trader’s trick that goes against the ‘common logic’ offered in a lot of trading books. But you should only use it when you see the potential for a big move on the horizon.
Scope out a decent run on the weekly or monthly chart, that’s ideally what you’re looking for. You can then use the daily – or even shorter – charts to fine-tune your entry point and set those tiny stop loss orders.
So whereas most short-term trading books have you entering a trade with your full position and then scaling out of the trade as the market moves in your direction, taking profits early, this idea turns everything on its head…
It locks in profits for the long term
And then forces them to grow exponentially as the market moves in your favour!
With the ‘probe-trades’ idea you’ll be entering an initial trade that may be just a fraction of the eventual position you hope to build. You then add to the position as the market moves – once it shows you that your analysis was correct.
So instead of risking the farm on one roll of the dice, with this you can afford to take multiple tiny losses as you try to establish your baseline position and simply hang on to your holdings when the market rewards your judgement.
Once the market makes a significant move in your direction, you can then go looking for an opportunity to add to the position.
So if it’s a trade to the upside you’re building, you might try to buy more contracts off any levels of support you’ve noticed. And again, you can afford to make multiple attempts to enter, taking tiny losses if necessary until your timing pays off.
Once you’ve bought your second batch of contracts you can then pull your stop loss order up to make the overall position a break-even proposition.
So let’s have a look at an example Pyramid trade
(I’ll use Gold as a theoretical example here):
a) Bought 1-lot of Gold ($/oz) at $1287.40. This was your first speculative probe. You bought off a prominent level of support but even still, there were no guarantees. In fact, let’s say this first foray into the gold market didn’t work out. You had a tight stop loss set at $1282.00 which was taken out. So you’re now down $5.40 per oz per contract (-$54.00).
Not the end of the world. After all, the first target level you’re eying is up there at $1500.00. It gives you a profit potential of $2,126.00 per contract.
So you watch the market over the next day or so. You decide your long term analysis still stands in good stead so you buy another contract to probe the market…
b) Bought 1-lot of Gold ($/oz) at $1287.89. Remember, you’re going back to square one here – probing for feedback. You’re looking for the market to prove you right before you add to the position.
So this time, the market does indeed move higher, carrying your trade along with it.
It reaches highs of $1306.64 within a day, showing profits on your probe-trade of $187.50. But don’t be tempted take your profits yet. You’re looking to build this position, remember!
The following day…
c) Bought 1-lot of Gold ($/oz) at $1293.79. The market had proven you right and you’d found a nice level of support to initiate a new buy order from. You’re filled on the order and the market moves up to highs of 1311.54.
Here’s how the overall position looks now:
1311.54 minus 1287.89 (Probe 1) = profit of $236.50 ($23.65 per oz/$)
1311.54 minus 1293.79 (Probe 2) = profit of $177.50 ($17.75 per oz/$)
Loss from first Probe Trade = loss of -$ 54.00 ($5.40 per oz/$)
Total current profit = $ 360.00
And with an average entry price on the 2-lot position of 1290.84 (1287.89 + 1293.79 ÷ 2 = 1290.84) you can now pull the stop loss to breakeven. You’ve built a two lot position that you’re going to let run and it’s now at zero risk. You can’t lose.
d) The market chops around for a week or so, and then makes a new break to the upside. You buy another contract as it goes. Bought 1-lot of Gold ($/oz) at 1314.55. You get stopped out for a loss on two occasions with losses totalling $110.00 before finally getting filled on a buy-trade you manage to hang on to at 1315.96.
Your overall position now looks like this:
1317.46 minus 1287.89 (Probe 1) = profit of $295.70 ($23.65 per oz/$)
1317.46 minus 1293.79 (Probe 2) = profit of $236.70 ($17.75 per oz/$)
1317.46 minus 1305.96 (Probe 3) = profit of $115.00 ($17.75 per oz/$)
Loss from first Probe Trade = loss of -$54.00 ($5.40 per oz/$)
Losses from third Probe Trade = loss of -$110.00 ($11.00 per oz/$)
Total current profit = $ 483.40
Do you get the idea?
Now let’s jump right ahead now to the close of this trade…
The market hit your $1500.00 target (you had your exit orders just below at $1498.50). And you offloaded your entire position because you expected heavy selling to come in at this huge resistance level.
You managed to add a few more contracts along the way (and you’ve also taken a few inevitable small losses).
Here’s how your overall closed position now looks:
1498.50. minus 1287.89 (Probe 1) = profit of $2,106.00 ($210.60 per oz/$)
1498.50 minus 1293.79 (Probe 2) = profit of $2,047.10 ($204.70 per oz/$)
1498.50 minus 1305.96 (Probe 3) = profit of $1925.40 ($192.50 per oz/$)
1498.50 minus 1320.50 (Probe 4) = profit of $1780.00 ($178.00 per oz/$)
1498.50 minus 1380.63 (Probe 5) = profit of $1178.70 ($117.87 per oz/$)
1498.50 minus 1420.34 (Probe 6) = profit of $781.60 ($78.16 per oz/$)
Loss from first Probe Trade = loss of -$54.00 ($5.40 per oz/$)
Losses from third Probe Trade = loss of -$110.00 ($11.00 per oz/$) Loss from forth Probe Trade = loss of -$38.00 ($3.80 per oz/$)
Loss from sixth Probe Trade = loss of -$51.50 ($5.15 per oz/$)
Total current profit = $ 9,565.30
Not bad. Especially considering the most you were ever at risk was around $100!
That was the loss taken on the first probe plus the stop loss provision when you retried to trade at that level.
Now compare that result to the guy who went all-in with his first order…
The first trade presented losses of $324.00 (after buying a full 6-lot at 1287.89 and getting stopped out).
He managed to hold on after that, but started to bail-out as the market progressed.
If he scaled out of his position in a typical manner, here’s how the results of his trade might look:
Sold two contracts as soon as $100 profit was banked = $200.00
Sold two contracts as soon as $200 profit was banked = $400.00
Let the remaining two contracts run. Out at 1498.50 = $4,212.20
Minus first loss of $324.00 = -$324.00
Total current profit = $4,488.20
$9,565.30 V’s $4,812.20? That’s a big difference.
Not to mention the mental anguish of taking such a big losing hit all upfront.
So that’s an example of how Jesse Livermore would build his pyramid positions using those little probe trades (he’d be doing it on a much grander scale of course).
Give it a try next time you see the potential for a big move on monthly or weekly chart. Get it right and you can make massive profits from tiny risk.
Be Prepared: Market Moving Data Coming This Week
Wednesday 26th October
15:00 USD New Home Sales
15:30 USD Crude Oil Inventories
Thursday 27th October
09:30 GBP GDP
13:30 USD Core Durable Goods
15:00 USD Pending Home Sales
Friday 28th October
13:30 USD GDP
Monday 31st October
11:00 EUR CPI
Tuesday 1st November
10:00 USD ISM Manufacturing
So, a quiet-ish week on the reports front but I’ll be watching those GDP figures with interest.
And of course, unexpected and unplanned events are only ever just around the corner too!
Trade safely and catch you next time.