"Pyramiding" – When and When Not to Do it
A frequent question I get from less-experienced traders is: "Should I add futures contracts to my existing market position?" That's a broad question and there is no single right answer. So, let's break down the question into some scenarios.
First, if your trading plan calls for the "scaling in" to a trading position, then adding to an existing position would be prudent. For example, let's say a trader plans on entering a long soybean trade with three contracts. His first "leg" into the trade may be at $4.40, and the second "leg" at $4.60 and his third "leg" of the trade would be at the $4.80 level. Thus, if the market action plays out the way the trader expected in his initial trading plan, he would be adding to his existing position twice. Again, this trader is adhering to his initial trading plan.
Let's look at another scenario: A trader enters a long soybean futures trade at $4.40, and he has an upside objective of $4.80. That is his initial trading plan. However, when prices hit $4.80, the general feeling among the "soybean marketplace" is that prices will track still higher--possibly much higher. The trader decides that instead of either placing a very tight trailing sell stop or exiting the trade (as was his original plan), he will add a couple more contracts to his already-profitable position--even though he did not have this idea in his original plan of trading action. This is not a prudent way to trade. Reason: The trader got caught up in the emotion of a bullish run in the soybean market. He got greedy. Emotions can destroy a trader. This is why trading plans should be strictly followed. Don't let the heightened emotions of being "in the market" influence your trading decisions.
The one emotion that can quickly take a person out of the fascinating business of trading futures is greed. In the last trading scenario, the trader who wanted to add to an already-profitable position was exhibiting greed. It was not enough for him that he could pull a $2,000 profit out of a single-contract trade (as expected in his original trading plan). He wanted more. It's this kind of rationale that many times leads to trading ruin.
Most veteran traders agree that adding contracts to a losing position is a recipe for disaster. Trying to "average down" a losing trade should NEVER, NEVER be attempted.
One more factor to consider when adding contracts to an existing position--even to a profitable one--is that a move against you is now multiplied by the amount of contracts you just added. While this is likely readily apparent to most traders, what is sometimes missed is the rapidity at which profits can evaporate when more contracts are added to an existing profitable trading position and the market then moves only modestly against you. You may lose all of your original profit--and then some--including getting a margin call.
Finally, many prudent traders of multiple contracts in one position will actually trade fewer contracts as their profits accrue. For example, let's say the soybean trader who had three "lots" (contracts) in the example above continues to accrue profits as prices rise above $5.00. He may then start to "scale out" of his winning trade by selling one lot at $5.10, and then one at $5.20, and then maybe he'll let the final lot "ride" with a tight trailing protective sell stop.