Is Your Pyramiding Strategy Limiting Your Returns?

Pyramiding in and out of trades is a very popular method used by many traders attempting to maximize profit while limiting losses. However, as with any generally accepted methodology, there is actually more to pyramiding than meets the eye.

There are many instances where pyramiding in or out of positions can actually reduce the overall return or increase the maximum drawdowns of a strategy. Knowing how to isolate and test each aspect of your pyramiding approach can shed a great deal of light on whether it is actually helping your strategy. Sometimes the benefits only exist in our heads.

Pyramiding in and out of positions is generally believed to be a good idea, but Mike shows that in some instances it can be ineffective.

Mike Bryant published a very insightful piece at System Trader Success that took a look at the different aspects of testing an exit strategy that scales out in two steps. The shocking part of the article is that Mike discovered that the system actually performed best when one aspect of the exit strategy was completely eliminated.

The Basic Strategy

The strategy that Mike uses for his article is designed to trade 15 minute bars on the short side of the mini Russell 2000 futures. His strategy establishes a full short position when it receives a signal and then exits half of the position based on one set of circumstances and the other half of the position under another set of circumstances.

When Mike’s strategy takes a new short position, it immediately sets an initial stop and a profit target. If the profit target is hit, the strategy takes a profit on half of the position. The other half of the position adjusts its initial stop to the breakeven point and uses a trailing stop to secure any additional profits.

This strategy represents the basic concept of taking a portion of the profits off the table and leaving the rest of them to run. This is generally accepted as a good idea, but Mike discovered that it was actually hurting the system’s overall performance.

Testing Multiple Exits

In order to test the impact that each of the exits had on the overall strategy, Mike programmed them as two separate strategies and tested them as a combined system. Each of the strategies was programmed to take half a position on each entry and then follow its specific exit criteria.

Using a program that allowed him to optimize how much of the total position should be allocated to each exit strategy, Mike found out that the best overall system would allocate 100% of its capital to the system that based its exits on the trailing stop. Therefore, taking half the position off of the table at a certain profit level was counter-productive in the long-run.

Mike specified in his optimization program that he needed to keep the maximum drawdown under 30%. Using that as a maximum, the combined system returned a net profit of $82,000 on his backtesting data. Maintaining the same maximum drawdown and allocating the entire exit capital to the trailing stop version produced a net profit of $129,000.

Of course, this doesn’t mean that pyramiding is always a bad idea. This is just one strategy that is focused on one specific market and time frame. The important concept is that we must find a way to test all of our assumptions.