When I was a little girl, my sister and I raised the skill of building card houses to an art form. Each day we would try to out-do our previous record. Sometimes we would succeed in creating the ‘Taj Mahal’ of card houses that would practically withstand an earthquake (in our minds at least). Other times, we could barely make it past two levels.  The method I learnt all those years ago is exactly the same as the technique I use in trading to add more capital to a winning position. Let’s review some of the major success factors when pyramiding into a trade, or building card houses.

Don’t go too high
Unless you are aiming to enter the Guinness Book of Records for card-house building, three layers will usually be enough. With trading, if you pyramid more than three times, usually your position size will grow to be too large in relation to your trading equity. This does not represent effective risk management.

Don’t go too quickly
Wait until your trade is at least profitable before attempting to add money to it. Set your pyramid points slightly above a level of previous resistance, and above a round-dollar figure. This suggests that the share must bullishly break through a psychologically significant price, before you show continued faith in the upward potential of the stock.

Make sure each layer is smaller than the previous one
The strongest card houses have a firm foundation. If you are used to position sizing in trading based on a percentage risk, you could follow a method that looks like the diagram.

Per cent risk per position
If you are used to adding fixed dollar amounts to your trades, you could use this diagram to signify units. For example, you may commit $10,000 to a position. The next position could be $5000, and the final position $2500.

Never average down
If the card house is looking shaky, don’t add more cards. If the trade is not co-operating, don’t throw more money at it. Averaging down means adding more money to a losing position. It doesn’t work… and I can prove it to you. Let’s say that you decided to buy 500 shares at $15. Imagine that the share price drops, so in your infinite wisdom, you decide to buy another 500 shares at $12. As the share price dropped further, you also decided to buy an extra 500 shares at $10. After this, your average price would be $12.33. Now you own 1500 shares in a stock that is downtrending. Well done – you must feel very proud!
Instead of buying more of this downtrending share, it would have made more sense to exit at your initial stop loss of $14 and capped your loss at $500 ($15 – $14 x 500 shares). To contain your loss to only $500 after you have averaged down, the share has to trend from $10 back up to $12. How likely is a share price increase of $2 or 20% when the share is already in a confirmed downtrend? This is a very unlikely event in the near future. This is why averaging down doesn’t work.
The more times you average down, the greater the commensurate increase in share price is required in order for your total position to break even. Only add money to a winning position, or suffer the consequences.
Unfortunately, most traders do not have a clear idea about how to pyramid effectively, and they end up devastating their own trading results, even if they have correctly identified the trend. If you follow these suggestions, pyramiding, and building card houses, will be so much more effective for you.

Louise Bedford (www.tradinggame.com.au) is a full-time private trader and author of four best-selling books – The Secret of Writing Options, The Secret of Candlestick Charting, Charting Secrets and Trading Secrets. Register on her website to receive a free trading plan template and a 5-part e-course to get you trading like a machine.