A Pyramid Strategy In Frustrating, Trendless 2011

Includes: AGQ, NFLX
by: Chris Kacher and Gil Morales

If you are a trend-follower, the market's volatile and choppy tendencies in 2011 have made for one of the most difficult environments for catching profitable trends. In this market environment, any trend that begins to develop tends to be short-lived. For example, our market timing model at Virtue of Selfish Investing did catch the steep drop in early August with a sell signal on August 2nd, as well as part of the market’s steep ascent in early October. But these profitable trend signals have been sharp, short affairs, and any gains made during such movements end up being whittled away when the short-lived trend turns into a “chop zone.” Thus, we think investors can best avoid dying the “death of a thousand cuts” by taking a slower pyramiding approach in this market so that if a trend signal proves to be false, risk is kept to a minimum.

For example, for fundamentally strong, fast moving stocks or focused ETFs (relative strength >95), one could add a fixed % (say 20%) to one’s initial position each time the stock or ETF advances 10%. For example, earlier this year, we pyramided 2-times silver ETF AGQ. We had bought both gold and silver ETFs in 2009 and 2010. In 2011, on the February 17 base breakout of AGQ, we bought a 20% position at 80.82, the high of the basing pattern. We then added the same number of shares each time the stock advanced 10%. This means our subsequent positions were 22%, 24.2%, 26.6%, and so on. Less aggressive investors could simply add 20% each time, meaning a fewer number of shares would be bought each time the stock rose 10%. Our position size grew quickly since AGQ went on a big run. We bought more AGQ at 88.9, 97.79, 107.57, 118.3, 130.16, then stopped buying as AGQ became a huge percentage of our portfolio. We sold on May 2 after a clear climax top, then subsequent gap down on huge volume. Such pyramiding campaigns make all the difference to one’s portfolio. As we like to say, when it comes to investing, the chance of a lifetime comes along every few weeks or months. You just have to keep a focused eye on the markets, run your screens every day, and never let fear interfere.

With a stock or ETF that does not move quite as fast, but still exhibits leadership qualities, such as Netflix Inc. (NASDAQ:NFLX), one could starting buying at the breakout on August 10, 2010 at 125. If one bought a 20% position each time the stock rose 10%, they would buy at 125, 137.5, 151.2, 166.3, 183, and 201.3 for an average cost of 160.7. One may decide to limit their size to 50% of their portfolio in which case they would buy 20% at 125, 20% at 137.5, then 10% at 151.2 for an average cost of 135.24. Note that since one is averaging up, NFLX tends to trade above their average cost. This is psychologically reassuring to the investor.

More conservative investors may want to only add 10% each time the stock advances, say, 20%. For more conservative investors who wish to invest in stocks not moving quite as fast, one could add 10% each time the stock advanced 10%. One would then set a trailing stop which is a stop that rises as the stock rises in price, thus locking in gains on a profitable buy or minimizing losses on an unprofitable buy. This puts investors in the position of forcing the market and/or their stocks to prove themselves before committing further, precious capital.

Note that instead of a fixed percentage, one could use various pivot buy points as the leading stock continues higher as there are many ways to pyramid a position. The key is in averaging up, not down. Strength begets strength. And if your stock turns out to be a dud, since not all stocks with a beautiful fundamental glow will necessarily outperform, the stock will hit your sell stop, so you can redeploy that precious capital into another stock showing great potential.

Remember, legendary investors such as William O’Neil, Jesse Livermore, Gerald Loeb, and Bernard Baruch always looked to pyramid into the next leading stock. Leading stocks can trend for many weeks if not months. The big money is made by finding the best then pyramiding into the best.

The advantages to this strategy are three-fold:

1) Leading stocks are the ones that often move up hundreds of percent in a bull market in extended upside trends. This is where the big money is made. As Jesse Livermore used to say, it is the uncommon man who can “be right and sit tight.” But we cannot know ahead of time which stock or stocks will be the big winners. Pyramiding allows the investor to let the stock prove itself on a price basis before adding to their position.

2) Smaller losses result if the buy proves false since it is unlikely one would even have had the chance to pyramid on a false buy since the stock never would have advanced enough, thus their position size on the loss would be smaller.

3) The longer the stock trends, the higher it rises in price, and the higher one sets their trailing stop. Thus one’s position size grows as a function of the rising price as well as having added to (i.e., pyramided) their position as the stock rises. Yet one’s average cost should in most cases remain under where the stock is trading, even when it does finally hit its sell stop. Thus one makes their winning stocks count by having a substantial position in a winner. William O’Neil was eventually elevated into billionaire status by pyramiding into stocks in this manner from 1963 onward.

This strategy also has the psychological advantage of allowing an investor keep their focus on the markets without getting disgusted with continual capital losses since the losses should be quite small. Then when a new trend emerges, one will be there to ride and pyramid the new trend.

Meanwhile, 2011 has caused most all of the trend following wizards to be down. These are the traders interviewed in Jack Schwager's "Market Wizards" books and Michael Covel's "Trend Followers". Many have suffered double digit percentage losses.

While we are trend followers at heart, pyramiding allows us smaller losses on false (unprofitable) buys. We also use tools and experience distilled into systematic rules that allow us, at times, earlier entry and exit than other trend followers.

That said, 2011 has been challenging for most all of us due to its news-driven, gap up/gap down, volatile nature. Experience has shown that trying to preempt or second guess the markets based on impending news events hampers returns over time as it can often prematurely push an investor out of a winning position.

The 50,000 foot view is that 2011 is an aberration driven by the tug-o-war between quantitative easing which lifts markets in a somewhat grinding manner vs. negative news which causes the market to gap down, thus explains how so many excellent long term trend following wizards have lost substantial sums of money this year as a trendless market chops them up.

When conditions eventually right themselves, and they will since markets cannot stay choppy and trendless forever, these championed trend-following traders will again excel.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.