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In this weekend’s episode of Pancakes and Pivots, we addressed the issue of how to allocate risk in order to preserve your mental equity.
This is something I get asked about frequently, especially by new traders who are still in the early stages of figuring out their process. Now, regardless of whether you’re trading options, commodities, Forex, crypto, etc., it is absolutely crucial that you have a systematic approach to protecting capital. People like to say that trading is a form of gambling — putting money on the line for the “unknown”. I disagree with that. I see it more like betting on the Dodgers if they have Clayton Kershaw facing a guy with a 9.0 ERA. You know that 9 times out of 10 Kershaw is going to win that game. And creating those kinds of odds is what the PS60 Theory is all about.
Putting On Risk
Risk allocation refers to the amount of money in your account that you are putting on the line. Each time you consider making a trade, you’re evaluating risk for a possible appreciation in your account. So putting on risk is essentially what traders do for a living.
The question is, what’s a feasible allocation to put on for risk exposure? My answer is always that if you’re going to expose yourself to any risk, it should never exceed 1% of your account. Then you simply have to ask yourself how many shares you can buy to fully take advantage of a good risk-reward ratio. You know that you’re putting a stop at the previous closing price to lock in your maximum exposure. So you’re buying the amount of shares that gives you the highest possible reward with that maximum potential loss of 1%.
In the video, I use an example of trading with an account of $25,000. So in that case, my maximum risk allocation is $250. Now supposing that you find a stock with a logical stop at 5 cents, that means that you can buy $5000 worth of that stock to be risking $250. If you see that the next supply line is 50 cents higher, you’re talking about a $2,500 reward for a $250 risk. That’s a great opportunity.
Conserving Emotional Equity
I know a lot of you guys have sat and watched a stock tick-by-tick, praying to the market gods that it’s going to go higher. Years ago, I used to sit there and do that exact same thing. But if you think that’s in any way beneficial, you’re delusional. Worse, you’re burning emotional equity that you’re never going to get back.
Ultimately, when you have a defined process for risk allocation you give yourself a mental advantage over all the traders who don’t. You no longer have to sit there watching stocks every second, refreshing your twitter feed, waiting and hoping for something good to happen.
Setting your maximum exposure at 1% is a catalyst for a subconscious transformation. You’ll go from trading emotionally to trading technically. It slowly teaches you to free yourself from the emotional baggage that a lot of traders are still attached to. It gives you defined risk and, more importantly, a defined risk-reward ratio. And figuring out potential rewards isn’t a matter of forecasting. It’s simply examining historical price action of the stock and looking at the kinds of moves it has made in the past.
So if you believe that stocks trade from supply to supply and from demand to demand as the PS60 Theory continues to show, then trading at that 1% defined risk is a sure way to preserve your mental equity. It doesn’t happen entirely overnight, but it does gradually help you to trade with a technical process devoid of the emotional baggage that causes traders to make dumb decisions. And that’s ultimately going to reduce losses and make you consistently profitable.
For a more in-depth look at risk allocation including several practical examples, check out Episode 2 of Pancakes and Pivots below.
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