Double the Risk for not Double the Profit

While writing my new book ‘Better Spread Betting’ (which is currently ‘under development’, so you can’t buy it yet) I found myself writing the following sentence in relation to pyramiding. Or rather, in relation to not pyramiding.

“Ah yes, but at double the initial risk for not double the profit”

The point I was making is that going into a position all gung-ho with a double initial position size may well generate more profit compared with pyramiding into the position gradually, but it won’t give you double the profit for the double initial risk you are taking! Let me demonstrate using the following chart for Enterprise Inns:

X marks the spot at which I established an initial £1-per-point position on this real-life trade, at a price of 29p-per-share on 28 December 2011. X also marks the spot at which I established a second £1-per-point position, at a price of 51p-per-share on 3 March 2012.

With the price sitting at 69p-per-share at the end of the chart, my accumulated ‘paper’ profit was £40 on the first position and £18 on the second (pyramided) position giving a total of £58 profit across the combined positions.

If I had established a more meaningful double £2-per-point position at the outset, I would have been sitting on a higher paper profit of £80 by the end of the chart, which is an almost 40% higher profit. But here’s the thing:

A double position size at the outset would have incurred double the risk; i.e. £58 initial risk in the double-position-size case vs. £29 initial risk in the gradual pyramiding case.

So the question is: do you think that a reward of £70 for an initial risk of £58 (ratio 1.2:1) is better than a reward of £58 for an initial risk of £29 (ratio 2:1)? Me neither, and that’s why I’m a big fan of introducing risk gradually through pyramiding. And the golden rule is to never establish a second (pyramided) position until the new risk is more-than-covered by the trailed stop order on the first position.

In conclusion, my Enterprise Inns* example is what led me to write the following sentence in my new (under construction) book’s manuscript

‘Ah yes, but at double the initial risk for not double the profit.’

Want to read more of my views on stop orders and pyramiding? Try these previous articles:

Position Trading #2: Stop Orders

Position Trading #4: Pyramiding

A Tale of Two Pyramids

* Note that I’m not recommending Enterprise inns or any other stock, and you should read the disclaimer.

Tony Loton is a private trader, and author of the book “Stop Orders” published by Harriman House.