Use The Pyramiding Method To Lower Risk On The Buy Side

Investor's Business Daily

Let's say that perfect stock you've been watching has finally cleared its in heavy , setting off a screaming buy signal.

You're tempted to go all-in because the stock's fundamentals are strong and the base was beautiful. But wait. What happens if the market tanks, or there's some bad news that sends the stock tumbling? You could lose a big chunk of change in a hurry.

Rather than investing all of your allotted capital at once, consider making a few, progressively smaller purchases at key points as the stock moves up from its buy point. This concept, called pyramiding, was developed by legendary investor Jesse Livermore as a way of reducing risk.

Typically, you would spend half of your allotted capital when the stock breaks out above its buy point. Then invest another 30% if the stock rises 2%-2.5% from the buy point and the remaining 20% if the stock climbs 4%-5% above the entry.

It's true you'd make more money if you invested the full amount at the , assuming the stock continued to rise. But it's also true that you'd lose more if the stock were to fall.

For example, if you invest all of your $10,000 savings in a stock that ends up falling 8% below the purchase price — triggering the golden sell rule — you'd lose $800. If you start with half of a position, you'd lose just $400.

In this way, pyramiding requires the stock to prove itself before you put more money to work. Yet "averaging up" isn't commonly used by investors.

"Most of them average down, meaning they buy additional shares as a stock declines in price in order to lower their cost per share," IBD founder William J. O'Neil wrote in "." "Why add more of your hard-earned money to stocks that aren't working?

Dollar General (DG) behaved well following its breakout. The stock cleared a 35.19 buy point in a on Aug. 30, 2011. Volume was 174% above normal.

The stock boasted a near-perfect 98 Composite Rating, putting it in the top 2% of all stocks based on five key IBD metrics. Its B+ Accumulation-Distribution Rating indicated strong demand.

An investor using the pyramiding technique would have made an initial purchase at the breakout. A second buy between 35.89 and 36.07 could have been established a few days later on Sept. 2, (1) when the stock rose more than 2% past the 35.19 entry.

Dollar General pulled back for two sessions to as low as 34.22. (2) It was not severe enough to force an investor to sell the first or second batch of shares. The stock found its footing and continued to climb. A final buy between 36.60 and 36.95 could have been made Sept. 14 as it rose more than 4% past the initial buy point. (3) Dollar General hit as high as 56.04 in July 2012, up 59%.

You can also pyramid when the stock forms a new base or pulls back lightly to the 10-week line for the first or second time.

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