Investors want certainty. Who doesn’t?
However, as investors, we all face a level of uncertainty as markets fluctuate. Recent market volatility is not the first time we have seen these fluctuations and nor will it be the last, as global markets change every day.
So, how do we protect ourselves and our portfolios from the constant movement and changes in the markets?
In this piece, we will discuss the merits of a strategy used by many investors who want a level of control at the same time maintaining their exposure in the markets. Though this may not work for you, it is worth looking into.
Jesse Livermore, the legendary stock trader known as the ‘Boy Plunger’, must have been one of the very first stock traders to have used this strategy with great success. In the book “Reminiscences of a Stock Operator”, the author described in detail the method employed by Livermore.
The strategy is known as pyramiding – which involves adding more to your existing positions as long as the stock price is going up.
Though this may sound counter-intuitive, it has its merits.
Going by Livermore’s strategy, he believed that a rising share price is a confirmation that you are into a good trade.
So, for example, if you bought shares in Atlassian (NASDAQ: TEAM) in October 2017 when it was trading at US$50.17, the strategy would have seen you buying more shares in March 2018 when the price pushed above US$60. We covered Atlassian in more detail here.
From its March 2018 level, Atlassian share price reached daily closing high of US$96.14 in September, which would have delivered hefty profits if you pyramided into your position from the original buy at US$50.17.
The basic principle behind pyramiding is to scale up to an already winning position and to capture bigger moves and ultimately bigger profits.
One of the most often quoted sayings in the investment world is to “cut your losses short and let your profits run”. Pyramiding is a form or letting your profits run. If done properly, pyramiding can help you to capture more profit.
Let’s look at another way that you can use this strategy as a risk management tool. This time when markets are volatile and prices are going against you.
While pyramiding (adding to a winning position) is best to use in a rising market, the opposite strategy – reducing your holdings when prices are going down – is also an effective way to cut losses.
Here’s how it works, let’s say you have invested in 1,000 Amazon.Com Inc (NASDAQ: AMZN) shares which you bought at US$817 per share in early 2017. You are still holding the shares and they have risen to US$1,900 in August 2018.
You know that Amazon is doing great business and expanding into many growth areas, so it seems reasonable to expect that the share price will continue to rise over time. Despite the recent market volatility that saw many of the IT and tech stocks drop in price, most analysts are still upbeat and recommending Amazon shares as a buy.
Assume that you share this view and that your own technical and fundamental analysis strengthens your opinion that Amazon shares have further room to rise in the months and years to come. However, amid current volatility, you decide that you want to protect the profit that you have accumulated over the past few months.
Using the pyramiding strategy (technically, the other side of pyramiding), you can scale down and reduce your Amazon holding temporarily. If you have an existing position of 1,000 Amazon shares, you can cut it back to say 700 shares (sell 300 shares) for example.
By doing this, you reap the benefits like:
・Securing and protecting the profit you have accumulated over the past year
・You still have remaining shares (700) which will once again rise in price if your longer-term analysis is correct.
Using the pyramiding strategy as part of your portfolio management tool is an effective way to lock in some profits while keeping your exposure to a stock that you believe has further scope to rise.
As an investor, you can use different variations of the pyramiding strategy. Here are some examples of how you can apply this strategy to capture more growth.
・Set the amount you want to invest in a certain stock – e.g. $10,000 to buy XYZ shares
・If the share price continues to rise you can invest another $2,000 to buy more shares
Some investors use a percentage metric to determine if it is time to add to their portfolio. For example, if a stock they bought has risen by 5 percent, then they will add to their position as the rise in price is a confirmation that it is a good trade.
If you use this strategy as a risk management tool, you can scale back on your position either by percentage or specific dollar amount in your investment.
For example, some investors want to scale down by 10 percent or 30 percent in the first instance. The idea is to lock in some of the existing profits while still maintaining exposure to the market and the potential revival of the upward trend.
Considering the benefits of this strategy, it may be worthwhile looking at how it works and how it can contribute to protecting your portfolio during volatile times.