We’ve all heard the age old adage, cut your losses short, and let your profits run. Yet the vast majority of traders don’t use this concept to its fullest. The proper application of this single, key piece of advice can be the difference between showing a profit at the end of the month, and showing a loss. This method is known as pyramiding your profits.

In order to properly pyramid your profits, you must understand a basic tenant of risk management. This tenant alone is enough to bring many an unprofitable trader to profitability, but only once combined with the idea of pyramiding profits, can its true utility be realized. This tenant states that no more then 5% of your portfolio should be at risk during any trade. Thus someone with a $50000 portfolio can risk $2500 on a trade. This doesnt mean they cant invest more then $2500, but it means that when setting a stop loss, your initial position size should be based on the $2500 number.

To determine your position size, what you do is you take the amount your willing to risk, and divide that by the amount your risking per share (the difference between the stock price, and your stop loss). So on a $20 stock, if your stop loss is at 17.50, and your risking $2500, then you do $2500/2.50 = 1000 shares. Your position size should be 1000 shares.

Now lets say the stock then moves to 22.50, and you move your stop loss to $21. At this point, you’ve looked in $1000 in gains. To pyramid your profits, you then add shares to the position based on the profit made so far. At this point, you have made $1000 in gains, and your risk amount was $2500. Add these numbers together, and then divide by the difference between the current stock price, and the stop loss to get the number of shares you should add to the position. So 1000+2500=3500/1.50=2300 shares. By doing this, you greatly increase how much you make if it continues to go up, while still keeping losses minimal should it go against you.

If it gets stopped out at 21, then you made gains of $1000 on the shares bought at 20, but you lost $3450 on the shares bought at 22.50, for a total loss of 2450, which is approximately how much you were risking on this trade. If it then continues to go up to $25/share, then you made $5000 on the shares bought at 20, and another $5750 on the shares you bought at 22.50, giving you a total gain of $10750, while only putting 2500 at risk. By adding shares, or pyramiding your profits, you substantially increased the potential reward of the trade, while maintaining a safe level of risk, and by cutting your losses short, and letting your profits run, your ability to profitably trade the markets will be greatly enhanced.

Make no mistake; this strategy is applicable to long term investors as well. Assuming youre invested in an up trending stock, then adding shares to your investment whenever it breaks above the last high will greatly assist in maximizing the profits from the big overall trends that appear in the markets. If you’re investing for longer time periods, its advisable to leave some profit in the case of it hitting the stop loss.

The interesting thing about this strategy is while its almost the opposite of some conventional wisdom ” you never go broke taking a profit ” it does strongly adhere to the idea of cutting losses short and letting profits run. The key is to do more of whats working, and less of what isn’t, and that’s exactly what this kind of trade accomplishes.

The most successful traders in the market aren’t the ones who are right on 80% of their trades. Many of the most successful aren’t right on 50% of their trades. A few of them aren’t even breaking 30 or 40%. What separates the best from the rest isnt how often their right, but how much they make when they’re right compared to how much they lose when they’re wrong. By pyramiding your profits, you’ll make massive gains, and small losses, which is a key to becoming a successful trader.

Source: Advance Stock