advantage of this or any- other pyramiding method is that an initial loss will be based on a smaller number of contrads than the final commitment

Adding Equal Positions

As larger commitments are added, an inverted pjTamid is created (Figure 23-12b) in which the risk of an immediate loss due to a small reversal becomes greater.

Adding equal numbers of contracts reduces the proportion of the original commitment in the event the trend does not materialize but increases later exposure (when, hopefully, there are large profits). The shift of rid; can only be determined by the trader. With this approach, as well as the other inverted pjTamid formations, the speculator should follow the rule that no unsuccessfiil secondary position should offeet the entire profits of the prior positions.

Adding Equal Amounts

To offset the effects of disproportionate risk, subsequent positions can be added based on the new value of the market being traded. Comparing this to the previous method of equal contracts, this would reduce the number of purchases in a rising market and increase them

in a declining market. The effect of increased volatility at higher levels would substantiate this approach to adding as a means of maintaining the same relative effect of each new position to the prior ones

Maximum-Leverage Compounding

The greatest rid; and the most potential is in adding positions using all profits accumulated to date. To do this necessitates a close working arrangement with the margin department of a brokerage firm. They might even want to install a direct telephone line. Whenever possible, new positions are added, based on the assumption that profits are considered a confirmation of the trend. Being completely leveraged is a tenuous position, requiring constant monitoring of the market; there must be a well-defined stop-loss at all times in anticipation of a premature reversal.

Reflectmg PjTamid

One way to reduce the extreme rids of compounding is to remove positions once a apecific profit level has been reached. For example, if there is a reasonable expectation of an average profit of 60 points, a reflecting pjTamid (Figure 23-12c) will add positions until the maximum commitment is reached at one-half the expected profit and then reduce positions until it is entirely closed out at 60. This technique can be modified to apply to any of the methods of adding positions by requiring that the full commitment be achieved at a level below the expected profit; full liquidation may be targeted for a point above the average profit.

Comparison of Compounding Methods

Table 23-6 and Figures 23-13a and 23-13b show the rids and rewards of three methods of compounding compared with holding a single position from trade entry to exit. All forms of pjTamiding increase both profits and rid;. Holding an unchanged position shows consistently lower retums with a mostly higher reward/rid; ratio, especially at early equity levels. Scaled-down additions show an improved retum and less attractive ratio; equal additions show much higher retums with a much lower reward/rid; profile. The reflecting pjTamid has both higher returns than the single position and an improved ratio. At one-half the expected rdum, it is clearly a better choice than the other methods. As expected profits are neared, the investor must choose between the exfremely high leverage and profits of adding equal positions and the excellent reward/rid; ratio of the reflecting pjTamid

EQUITY CYCLES

Every sjstem has profit-loss cycles that can be seen clearly by plotting its daily or weekly equity Trending techniques show that once or twice each year, there are major increases in profits corresponding to a frending market, at other times, there is a steadj decline and a stabilizing pattern to the total equity. For a sjdem to operate as it is expected, the positions must be kept constant. Increasing positions as equity increases in a frending cycle results in alwajs being folly invested at the top of the cycle, when losses begin. Losses will be on a larger base than profits, and equity will drop much faster than it increased.

The same effect can occur at the bottom of an equity cycle after a nonfrending market period. A sustained losmg streak may cause a apeculator to reduce the investment in proportion to dwindling capital. If this happens, the result will be entering into a profitable period with a smaller investment than the prior losing period. The sjdem must have disproportionately larger profits to recover the losses and achieve a net gain. An example of a tjpical sjstem is shown using a I00°o gain for each profitable cycle, followed by a 50°o loss cycle. Assume this cycle is repeated twice each year; in one year, the following equity pattem will occur:

TABLE 23-6 Comparison of Compounding Methods*

Ordinal margin Gain of 100% Loss of 50% Gam of 100% Lo« of 50%

-10,000 -5,000

+10.000 -5,000

$10.000

20,000 15,000 25.000 20,000

Second 6

This leaves a net gain of 100"» for the year. Each lOOo profit was 810,000, and losses were 85,1 1-the rate of return is always based on the original margin. Had the tycle started

FIGURE 23-13 Retums and rids from compounding, (a) Equity and liquidated value (10-point reversal), (b) Reward

to rid; ratio.