The key to avoiding bad decisions is to keep stress and emotional levels low. It’s hard to do that when there is too much money involved for you to handle responsibly. So we want to identify how much is too much. It’s not an easy answer and most likely something you’ll learn over time. When you get that feeling like you’ve just been punched in the stomach, you’re probably too big. You’ll know it when you feel it. Most of us have been there, multiple times.
The larger the position, the greater the danger that trading decisions will be driven by fear rather than by judgement and experience” – Jack Schwager
Two rules from Larry Hite:
- If you don’t bet, you can’t win
- If you lose all your chips, you can’t bet
I think this points to finding a balance. What is too conservative and what is too aggressive. My friends over at Riskalyze do a really nice job at helping you identify your risk tolerance. But from an execution standpoint, I think it’s a lot harder than just that. Coming up with a risk level for yourself is the beginning. To me, that’s where the process begins.
Then what? Well, I think it depends on what your goals are. Some of us can be a lot more nimble than others. If you’re moving around Billions, you can’t exactly put a hard stop on a single stock. The options market will help solve that “problem”. For most of us who are not throwing around 10 figures, we can be more disciplined on a intermediate to even short-term time horizon.
I learned this from other traders who came before me, but I think the math makes a lot of sense:
What we want to do is determine the point in which we are out of our investment. Where do we throw in the towel and admit to being wrong? In other words, there has to be a price between where you buy something and zero where you say, “Hey I was mistaken”. Once we determine where we are out of the trade, then we figure out how much money we’re willing to risk.
Here’s how the math works. I personally don’t like to risk more than 1-2% of the portfolio on any given position. That is likely to be different for many of you, some might think that’s too much risk, some might think it’s not enough. That’s fine. The point is to determine what that number is based on your specific goals and levels of risk tolerance.
The first thing I want to do is decide how far my entry point is from where I would admit to being wrong. Let’s say I want to buy a stock that is trading at $100 and, in my infinite wisdom, I believe that if prices fall below $95, then my thesis is most likely incorrect and we do not want to be long in that scenario. So I place my stop just below 95 (I always like to give it a little room: 25-30 cents) giving me a risk in this trade of approximately 5%.
For whatever the reason, let’s say I believe the stock gets to $120, which represents a 20% move higher from where I’m buying it. That means that I have a 1:4 risk vs reward proposition on my hands. I prefer something closer to a 1:7 or even higher. This needs to be another number that you have to decide for yourself, and that goes back to the risk tolerance, time horizon and overall goals.
For this particular scenario, let’s assume I want to risk 1% of my portfolio on this particular trade or investment. If I were to have $100,000 in my portfolio, that means I am willing to lose $1000 in the off chance that I may be incorrect in my assessment. So the math is simple:
Therefore, for me to express this thesis in trade form, I would need to buy 200 shares according to my specific levels of risk tolerance and objectives. This number will be different for all of us. The same math can be made in the futures and options market, just using contracts and more leverage. The idea is that we work backwards from where we’re wrong, how much money we’re willing to lose and then how best to express that trade according to our goals.
One thing I would add to this is that sometimes we get lucky an the entry point is very close to our stops. It happens. I wish it happened more often actually! But in these cases, the risk vs reward ratios can be very skewed, 1:30 or 1:40 or more, and using this math can create huge positions relative to the overall size of a portfolio. So I like to put a max on what percentage of a portfolio is in a single position or direction. It will be different for all of us, but 10% is a good number for me. Mostly because it keeps the math simple and there is less to think about. This number will be different for all of us as well.
This is a good table to keep handy. It shows the % gain necessary to make up a loss depending on the size of that loss. It points to keeping losses small enough to make up quickly. We know we’re going to take losses. That’s the deal we sign with the devil when we enter the market. But that doesn’t mean we need to give up big losses. The goal is to give them small ones:
You should place a stop at a level that disproves your trade premise, as opposed to placing a stop based on your pain level. The market doesn’t care about your pain threshold!” – Colm O’Shea
I’m not better than the next trader, just quicker at admitting my mistakes and moving on to the next opportunity” – George Soros
There is no wrong way to make money in the market. But I’ve found that it is a lot easier to keep the money you have than to make more money. Offense sells tickets but Defense wins championships, is how I learned it. Remember we can always get back in. Getting stopped and still being right on the direction is part of the deal we make with the risk management gods. It’s part of finding that balance between not enough risk and too much risk. It’s a personal decision.
We don’t have to be smarter than the rest, we have to be more disciplined than the rest” – Warren Buffett