Option Trading Subjects:
Option Buying Strategies, Option Selling Strategies
Pyramid In or Average Out?
"Pyramiding In" to an option position means you enter the position with fewer option contracts than your risk tolerance dictates, and add more contracts as the position moves in your favor, up to your maximum allowed risk.
"Averaging Out" of an option position means you enter the position with the maximum number of contracts according to your risk tolerance, and take profits by exiting contracts as the position moves in your favor.
The theory behind Pyramiding In is that you start with a lower risk, you make the position prove itself, and you end with at least partial gains on the maximum number of contracts allowed by your risk tolerance.
The theory behind Averaging Out is that you start with a higher risk, but lock in more and more gains as the position moves in your favor, until you are out of the position entirely with a gain on every contract.
The question for the option trader of course, is which strategy is likely to be better in the long run? We can only attempt to answer the question by making lots of assumptions. The main assumption is that stocks move up in regular amounts at regular intervals. In the real world, stocks are volatile and can have plenty of whipsaws. The whipsaws might work in the favor of Averaging Out rather than Pyramiding In, but they might not.
Another assumption is how good each type of trader is. For this example, let's assume that each type of trader takes four bullish positions. Two positions rise by $4 in three months. The other two positions show a complete loss on the initial number of contracts. The risk tolerance for the "Averaging Out" trader is $788.00, so we do not allow the "Pyramiding In" trader to exceed that. If he did his results would improve slightly.
You could argue that the averaging-out trader would see that his two losing trades weren't working out, and sell out before expiration. If the trader was good enough to cut his loses in half on the two losing trades, he would save $788.00, and the overall gain would be $58.00.
If the pyramiding-in trader was good enough to cut his loses in half on the two losing trades, he would save $197.00, and the overall gain would be $823.00.
Another common "Averaging Out" style of taking profits is to take gains on enough contracts to cover your initial debit as soon as you have them, and then hold the remaining contract(s) for a "free ride". If we use the same assumptions, this style does better than evenly averaging out, but is still a loser. It could be a winner, even a big winner, if the stock happens to zoom higher while you still hold "free ride" contract(s). But if that is the trader's intent, to capture the occasional big winner, he could speculate with OTM options instead, lower his initial risk, diversify his positions, and forget about averaging or pyramiding entirely.
For example, for the "free ride" shown below to be profitable, the stock would have had to reach about 36 by expiration on the two "free ride" contracts. If the trader had instead bought four 35 strike options expiring in three months when the stock was at 30, he would lose about $6 total on the two losers, and make about $150 total on the two winners if the stock reached 36 by expiration, which is a better result than "Averaging Out" for a free ride, on less risk. He would do even better by using the 32.50 strike.
If the free-ride trader was good enough to cut his loses in half on the two losing trades, he would save $788.00, and the overall gain would be $344.00.
For another comparison, how does a "buy and hold" option trader do using the same scenario? Assume the buy and hold trader buys the full number of contracts on entry, and then just waits for expiration. The buy and hold trader would have debits of 4 x $788, and credits of 8 x $400, for an overall gain of $48.00.
If the buy-and-hold trader somehow didn't hold the losers, and was good enough to cut his loses in half on the two losing trades, he would save $788.00, and the overall gain would be $836.00.