Risk & Reward 101

October 2018… Jeez, what a time to be alive huh? Dow Jones down 1,775 points, SP500 down 200 points at one point– roughly 9% drop. Not too shabby compared to the 53% drop back in ’08. Yet, we hear people down the street yelling, “CRASH! RECESSION! BEAR MARKET!” Yeah… not so fast, a 5-10% drop is a correction, not a crash nor is it a recession either; however, it is the time to be cautious– cautiously bullish.

Now is the time to accumulate my friends. What you choose to accumulate is up to you, this post will not be about what to buy, but how to buy so if you’re uninterested click away now.

Let’s talk about sizing risk. How many of us had the thought, okay I have $1000 in my account, if I go all in on this one penny stock, it will definitely go up sooner or later, it’s already so low, it can’t go much lower, I will for sure double my money, triple my money, buy a Lamborghini, this is it, tomorrow it will GO TO THE MOON! And tomorrow comes and it drops even lower, and you’re HOLDING AND HOPING it will go up the next day, and next day comes, and it drops even HARDER! How did I know you’ve thought of this? Because I’ve had these thoughts, many times in fact, and many times I’ve gotten burn thinking like this!

#1: HOLDING AND HOPING is a big NO NO. Cut your losses early and fast! This is why stop losses are invented. You never ever want to be in a position where a position has dropped so hard on you that all you can do is hold it. Set the stop loss, and if it triggers, be happy, it just saved you a lot of money. And what if your stop loss was triggered, and the stock started running right after? Do you chase it? Good guess, you should generally never chase a stock, and I say generally because maybe there might be a time where you see a good risk/reward opportunity. Key words: risk/reward. If a stock starts running, you have to have a plan of reward to risk ratio in mind before you decide to chase after it. If the reward to risk ratio is anything lower than 2:1, just don’t. Save yourself the pain and anxiety. The golden ratio is actually 3:1 and higher.

#2: Sizing risk: Knowing how to size your positions is a HUGE factor that separates the newbies from the pros. Every trader starting off, always seem so confident, putting 50% sometimes 100% of their entire portfolio value at risk, expecting these huge returns, but in the end, they get huge losses. And if not then, they will eventually. Have a set sizing rule for yourself. One that I find works for me is 5, 10, 20. If I have a $10,000 account, most of my trades are 5% of my portfolio, or $500. Sometimes I would enter $500 at once, other times I would size in to test the waters, going in with $250 and going in again with $250 to complete my 5% rule. If I’m really confident with the trade, I might size my risk to 10% of my portfolio, and if I’m EXTREMELY confident I would think about running 20% and I would think twice before I do, and I ask myself if I lose $2,000 on this trade will I be okay tomorrow, and if the answer is yes, I pull the trigger. Do not trade with money you cannot afford to lose!

Pro tip: You would generally want to double down on your position when the trade is going your way. Sounds counter intuitive doesn’t it? Putting in more money when the price has already gone up? Yeah, it blew my mind too when I first heard of that, but think about how clever that is. You go in with $250, and the trade starts going against you and your stop loss is triggered. Great, you just lost on a 2.5% trade. But you go 2.5% in, and you were correct on your thesis, and your position goes up! Double down! Complete your 5% rule, and watch that baby rise up and lock in your profits!

#2.5: When to QUADRUPLE down when the trade goes against you. Pro tip coming in hot. Say you entered 2.5%, and the stock price drops, but you know deep down in your guts that this is just a minor pullback, it will go up, so you double down with 5%. And then the price continues to drop even more! Depending on your risk tolerance, and confidence in your thesis about the play here, you can double down to 10%. So you double down, $1000 in play here, and BOOM the stock price bounced off support and starts to run! When the stock price hits your average cost, DELEVERAGE! Pull out 5%! This is a lot easier said than done when you see your position gaining money. It is hard to pull money out isn’t it, especially if you’re taking money out at the same price you got in. But you have to be strict with yourself, and play by your rules. 5% is 5%. The reason why you quadruple down to a 10% position is to lower your cost average so you can deleverage later and reduce your exposure to risk, it is not to make more gains. Read this rule again, and really think about it. It blew my mind when someone told me.

Stock price at $5.00. Buy order: 50 shares @$5.00 = $250 (2.5%) Cost Avg: $5

Stock price at $4.17. Buy order: 60 shares @$4.17 = $250.20 (2.5%) Cost Avg: $4.55

Stock price at $3.50. Buy order: 143 shares @$3.50 = $500.50 (5%) Cost Avg: $3.955

So when the stock price bounced off support at $3.50 and starts running, you would want to deleverage half your position at $3.96, and let your 5% ride. Or, in most cases by this time you would have lost confidence in this play, and exit the trade completely at $3.96. Quadrupling down gave you the opportunity to exit without a lost at $3.96 instead of needing the price to be $4.55 to break even. However, this was a drastic example, and if you were smart, your stoploss would have triggered way before the price dropped to $4.17, and if you were really smart, you would not have doubled down at $4.17 either, right?

Rule #3: LOCK IN YOUR PROFITS! This is a rule so many people fail to follow. It’s easy, if you’re green, and you’re asking yourself when should you lock in your profits, you should probably lock in your profits! Nobody ever went broke locking in profits. So what if the position is up 30%, you want 100%! Or even 1000% if you’re playing options! Big no no. Lock in your profits! A lot of people are happy to beat the market’s 7%, and you’re up 20, 30, 40%, you shouldn’t be hesitating to lock in profits. 10 20% wins are a lot easier to find than 1 200% win. In the market, CONSISTENCY is KEY! If you’re bagging these 200% wins once out of 10 trades and losing the other 9, you are doing it wrong! Bag 9 20% wins and lose one. You’re on the right track.

Hopefully this write up helps someone out there before they blow up their account. Wrote this as a reminder to myself as well. Full disclosure, I have broken all of these rules before, and it hurts. If you haven’t been there, I hope you don’t. It’s cheaper to learn from someone else’s experiences than your own, but not everyone can and not everyone will and if you’re that someone, I hope you learn quick, because the market is ruthless. It doesn’t give a fuck about you or your money and it will eat you up alive if you don’t respect it.

Catch ya later. -T


2 thoughts on “Risk & Reward 101

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.