Buying On The Way Up Cuts Risk In A Position

SymbolPriceChangePNRA119.850.00{“s” : “pnra”,”k” : “a00,a50,b00,b60,c10,g00,h00,l10,p20,t10,v00″,”o” : “”,”j” : “”}

The genius of the ancient Egyptians can be felt with one look at the pyramids.

How have these monolithic structures stood up to the withering effects of time? They have a wide, sturdy base. Upper levels of the pyramid hold fewer and fewer slabs of stone until the apex is reached.

A proper position in a stock can adopt a similar architecture. Form a “pyramid of shares” with a three-step buying process. Use this technique to put more money — less each time — into a stock only when it is acting right. You’re raising the potential for a big reward but also reducing your risk.

When you buy a stock that rockets out of a solid basing pattern, you could buy all the shares to create a full-size position right off the bat. But if the base is faulty and the stock quickly falls, you’ll take a loss on the entire stake.

The pyramiding process goes like this: Let’s say you want to build a $200,000 position in Wonderful Widgets as it breaks out past a $50 buy point. Instead of grabbing 4,000 shares at 50, buy 2,000 shares for $100,000, or 50% of the target position size.

If Widgets rises after you bought it, good. That’s the time to add shares.

When the stock rallies 2% to 3% from the proper buy point, buy an additional 30% of the intended full position — in this case, it’s another 1,175 shares or so when the stock rises to 51-51.50. Now you’ve completed 80% of your full position.

If Widgets rises to 52-52.50, or 4% to 5% above the initial entry point, buy the remaining 20% of the total position, or 800 shares. The pyramid is built. If the stock does not climb 2%-3% and reverses lower, you wouldn’t make the second buy. You’re facing a potential loss with a smaller stake.

Panera Bread (NASDAQ:PNRA – News), one of the most successful restaurant stocks in recent years, shows how pyramiding buys can work.

The stock bolted out of a six-month cup with handle on Oct. 28, 2009. For a $200,000 position, you would buy 1,700 shares at the 58.34 ideal entry 1. As it rose to 59.50, you would add 1,000 shares, and then 700 more shares at 60.67.

You could have built the pyramid during the first three days of the rally 2. Panera gained 52% over the next six months.

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