How to Lose 100% AND Sleep Well at Night
Have you ever had a super high win rate for the year, only to finish the year with a net loss?
After reading this article, you'll never be one of those people who allow that to happen.
There's obviously been a lot of talk about my track record lately, and I have to confess: it's making me nervous! I feel like most of the people asking me about it are REALLY missing the point. The fact of the matter is that it's possible for anyone reading this article to have an 80%+ win rate but still lose most of their money!
Some of you may already know, first hand, what I'm talking about. Whether you've experienced this already or not, I can't just stand by and let you take that risk anymore, so today it's time to show you how professionals do it.
It would be dangerous and perhaps irresponsible of us to focus too hard on just my track record, or my upcoming market recommendations and analysis alone. So today, before I publish even ONE MORE of my trading ideas, I dedicate my article to the critical "other half" of the story ...
THERE ARE 2 KEY ASPECTS TO PROFITABLE TRADING AND INVESTING:
1. Having a solid approach to finding sound trading ideas to put your capital to work.
2. Deciding how much of your capital to put into each idea.
The focus this week is on the latter.
Sadly, this is the most overlooked, yet most important, lesson to learn before putting your hard earned money to work for you in the market.
Responsible position sizing, commonly known as "money management", is critical to your success in the financial markets.
You might think you have adequate money management skills, but several studies show that most investors actually don't. In reality, it comes down to discipline -- but today we'll be SURE it's a skill you'll possess.
Why is money management so important?
This game changer separates successful investing from the unfortunate alternative that wiped out trillions of dollars of investors’ net worth, especially in recent years.
The credit crisis, which wreaked havoc on the financial markets, left deep scars in many portfolios due to neglect. Most investors would have lost a fraction of the amount they did IF they had had the proper money management rules in place --but whether you made it out of the crash with your shirt or not, it's never too late to make sure this won’t ever happen (again).
All of the successful traders I've ever known (with the exception of a very lucky few) had a disciplined approach to "Position Sizing". They all know it's the critical part of their trading style and risk threshold that tells them how much to risk on any one position.
There are general rules of thumb, but ultimately this answer will take some individual thought on your objectives and risk appetite. Hopefully this guidance will weigh in on your decisions.
DOES SIZE REALLY MATTER?
Here is the answer, short and sweet: YES!
Position sizing is the difference between long term success and short term failure, because without proper discipline you're always just one trade away from making that one big mistake that you'll regret forever. Would you play Russian roulette? What if, instead of risking your life, you only risked your net worth? If not, then you MUST implement the money management strategies I'm about to cover.
Believe me, I've been around the block for quite some time from my days as a market maker on the options floor. I have witnessed all types of perilous markets, and what kept me successful was maintaining a strict discipline on my position sizing.
I've known far too many great traders who blew out (experienced financial evaporation) simply because they got in way too deep on one particular position that sunk their business! It can happen to professionals as well as individual investors, and it's a common pitfall that must be avoided at all costs!!
If you want my personal feeling on money management, my general appetite for risk is to not expose my account to more than a maximum potential loss of 5% on any one trading idea.
Our account balance is $50,000.00.
Our money management risk threshold is 5% on any one position.
Therefore, the most we are willing to lose on any position is $2,500.00, whether trading stocks or options -- PERIOD.
Position Sizing in a Long Stock Example
The stock we like is trading $20.00 and we are looking for the stock to rise $3.00 as our profit target. If the stock trades down, we will place a stop-loss 10% below our purchase price (which works out to $18.00) and exit the position if we are wrong. That's a max risk of $2.00 per share.
Now that we have our risk parameters in place, let's calculate the optimal size (how many shares we can buy) on this trade idea.
A 5% loss on $50,000.00 is $2,500.00 -- That's the most we will tolerate!
If we divide the $2,500.00 by the $2.00 stop-loss, we calculate 1,250 shares. This position size, if we get stopped out, will give us the maximum loss we are comfortable with.
(Keep in mind, you don't have to use a certain max-percentage-loss such as 10% as a static rule. If the chart of the stock tells you that a 15% - or 3 point - decline would be the right place to sell, then you would simply divide the $2,500.00 by a $3.00 stop loss and trade 833 shares.)
Hopefully we will be right and make our profit target of 3 points on 1,250 shares, or $3,750.00. The key point is that we have created a risk/reward profile that meets our disciplined investing guidelines. The stop-loss assumes we can sell at our trigger point, $18.00, but the major flaw in that "stop-loss" strategy is a "gap" in the stock price below our stop-loss. For instance, what if the stock closes at $20.00 but opens for trading the next day at $13.00? You'll end up with a $7.00 loss ($8,750.00)!
This is a risk that stock traders unfortunately have to endure and, frankly, I find that unacceptable. So instead, I take the equivalent position in options, which is my investment vehicle of choice.
Here's how I prefer to bank profits AND sleep well at night ...
Position Sizing in an Option Position Example
We will assume the same criteria; our account balance is $50,000 and our risk threshold is 5% on any one position. The stock price is again $20.00, and we are looking for a 3 point move higher as our profit target by the end of the year.
The distinct difference is that we are going to replace the stock position with a "Bull Call Vertical Spread." Sweet!
We are going to BUY the Jan (2011) 20 Call and SELL the Jan (2011) 23 Call.
This vertical call spread can be purchased for $1.20 per spread, or $120 each.
We can only lose what we pay for the spread (which will be about the same amount of risk as the stock trader took) and our profit is capped at our target price of $23, meaning our profit potential is $180 per spread.
Now that we have constructed our bullish option strategy, we need to focus on how many spread contracts meet our risk parameters.
If we can risk the same 5% of our account balance, that is still $2,500.00. If each spread costs $120.00, we can Buy 20 spreads, limiting our total risk exposure to $2,400.00 ($120.00 x 20 = $2,400.00).
If the stock moves up to $23.00 or higher, our profit will be $3,600.00. The key point here is, again, that we created our defined risk/reward profile based on our investing guidelines.
Stock position potential gain: $3,750.00
Stock position potential risk: $2,500.00
Option position potential gain: $3,600.00
Option position potential risk: $2,400.00
(If you don't see a clear difference yet, bear with me ... it's coming.)
Stocks/ETFs vs. Options
Both examples clearly address money management through position sizing. Both examples have similar risk/ reward characteristics that meet our objectives.
One big difference is that the option strategy defends against adverse gaps in stock price, which is attractive. So if the stock gaps down, unlike the stock trader, we know that with the options our loss is TRULY limited.
Another difference is that, with less capital outlay in the options position, it allows for more positions to be maintained, and diversification is very important.
IMPORTANT NOTE: The following key point is one that confuses some newbie of options, so pay very close attention here so you aren't mistakenly discouraged from trading options (the smarter and safer route):
The STOCK position sizing example:The stock position loses 10% ($2,500.00) in value on the stop-loss at $18.00 (a 2 point decline from $20.00), but the trading account, as a whole, loses a maximum (assuming the stop-loss works) of 5%.
The OPTIONS position sizing example:The options position loses 100% ($2,400.00) in value, which seems alarming on the outside. But the 100% loss on the trade still equates to a 5% loss in the account value as a whole.
This point is important to hammer home, because in options trading you can have 100% losses on any one trading idea and still reflect a sound and superior money management system. This is why it is crucial to position size properly so you properly harness the power of the leverage it affords you.
The stock example has you lay out $25,000.00 (or, over half of your capital) to get the 1,250 shares stock exposure, and the equivalent options strategy has you lay out only $2,400.00 for the same exposure!
Again, smaller capital outlay per position allows you more flexibility to diversify your account, and as we all now know, diversification is tied for first as the number 1 most important trading/investing rule!
Because the Institute for Individual Investors understands the importance of position sizing and money management, we created a suite of position sizing tools on our products that addresses this point, and it is a focal point in my Profit Skimmer service.
Whether you take advantage or not, you'll still see me here in The Tycoon Report. Here are the three key takeaways that you absolutely MUST have engraved in your brain:
1. Start small with the trading ideas you wish to pursue until you find your comfort zone on how much you are comfortable risking. You can always gradually increase your risk exposure, but it's painful to wake up one day realizing you had too much at risk.
2. Know your total risk/reward exposure before you enter into any trade, no matter what your investment vehicle of choice may be.
3. Obviously every investor has a different comfort level or risk tolerance. I feel comfortable risking 5% of my account value, but then again, I know I'm right on my trade ideas most of the time. If I'm right most of the time then why don't I start risking 10% or 20%? Because with that max-risk, if I have a string of losses (something everyone goes through at some point) I run the risk of trading emotionally out of frustration. If I don't feel comfortable, I may not maintain my win rate. You get the point. I'd rather have a high win rate with less money than have a low win rate with more money.
What If I'm Trading a Volatile Stock?
I want to be thorough here with you because I can't overstate the importance of money management skills. I finally get to explain this to hundreds of thousands of readers, so at the very least I can go on with my life knowing I've helped a fair amount of people to not take huge losses again.
Rather than just give examples on how I personally feel comfortable with my own style, where only people like ME would benefit from this, I want each and every one of you to grow your wealth over the years, so let's talk about ways to adjust your positions so it fits with YOUR style.
What if you don't want to trade options and you only want to trade stocks and ETFs?
Instead of the 10% stop loss in my earlier example, what if you want to allow stocks to fluctuate by 25% before exiting? Some of your biggest winners are going to be the most volatile.
Maybe your comfort level is to have lots more diversification and allow for more fluctuation, and you don't want to trade as often. Maybe you're more of an investor for the long-term.
Let's also reduce the amount that you risk on a position.
Example For a Different Animal in a Different Zoo
If you have a portfolio of $100,000.00 and you decide to only risk 1% of the account value on a trading idea that you have, you are risking $1,000.00.
The $1,000.00 is the amount RISKED on the trade idea and should not be confused with the amount that you actually INVESTED in the trading idea.
Now suppose you decide to buy a stock at $23.00 per share and you place a protective stop at 25% away, which means if the price drops to $17.25 you automatically sell the stock.
Your risk per share in dollar terms is $5.75. Since your risk is $5.75, you divide this value into your 1% allocation (which is $1,000) and you are able to purchase 173 shares, rounded down to the nearest share.
Work it out for yourself, so you understand that if you get stopped out of this stock (i.e., the stock drops 25%), you will only lose $1,000 or 1% of your portfolio. No one likes to lose, but if you didn't have the stop and the stock dropped to $10.00 per share, you can see how quickly your capital can vanish.
Another thing to notice is that you will be purchasing about $4,000.00 worth of stock. Work it out for yourself. Multiply 173 shares by the purchase price of $23.00 per share and you’ll get $3979. It would probably be around $4,000 when you add commissions.
Thus, you are purchasing $4,000 worth of stock, but you are only risking $1,000 or 1% of your portfolio.
And since you are using 4% of your portfolio to buy the stock ($4,000), you can buy a total of 25 stocks this way without using any borrowing power or margin, as the stockbrokers call it.
This may not sound as “sexy” as putting a substantial amount of money in one stock that “takes off,” but that strategy is a recipe for disaster and very rarely works out. Therefore, it is best left on the gambling tables in Las Vegas.
To continue to analyze and stay in the market over the long term, learning position sizing and protecting your initial capital is vital.
People who understand position sizing and have a reasonably good method can usually meet their objectives through developing the right position sizing strategy.
Well that's all for me. Trade and invest safely, so when you're wrong you live to fight another day. I'll see ya next week right here in The Tycoon Report!