Pyramiding

A staged way of building exposure in which each addition is made only after the part already held has moved favourably, conventionally in decreasing sizes so the largest tranche is the oldest and the best priced. It is the opposite in construction to averaging down, which adds to a position that is losing and therefore increases exposure as the loss grows. The name describes the intended shape of the tranches rather than any property of the market.

The arithmetic is what the practice actually is. Each addition raises the notional value, and every subsequent move is calculated on the whole of it: losses are calculated on the full contract value of the combined position and are not limited to the amount deposited, and a favourable move is calculated on exactly the same basis. The average entry moves towards the market with each addition, so an unrealised gain assembled over several tranches can be given back on a move materially smaller than the one that produced it. Margin rises with each addition too, reducing free margin and moving the account closer to its close out level.

The two readings of the practice describe the same arithmetic and disagree about what it means. Trend following literature presents it as a way of concentrating exposure where a move has already extended and of keeping the first tranche's better price inside the average. Its critics point out that the same mechanism concentrates size at the least favourable prices and at the point when a move is oldest, which is where the sequence is most exposed to a reversal. The conventions that travel with it, sizing each tranche smaller than the last and moving the protective level to the combined break even, are conventions circulated among practitioners rather than results established by evidence.