Teeka Tiwari

How Much Do You Really Have at Risk?

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So, if we use the fictional $9,800 account, you are risking 2% of total portfolio value per trade, or $196. To apply the true equity value rules, we have to remember that the 2% risk parameter is on a sliding scale based on the cash in your account and the "stop" value of any open positions.

So, while your first trade may allow you to risk $196, your other trades may not. It will depend on the most current value of your true equity.

Using the earlier example of the seven trades, we would value each stock not at its market value of $14, but rather at its stop-loss value of $12. Any new position would be based off a true equity value of $8,400, not the market value of $9,800.

Guard Against 'Gap Risk'

Let me go over it again: We work out "true" equity by valuing our holdings as if they were trading at their stop prices, plus any cash or cash equivalents we hold in the portfolio. The number that we get is the number we use to base our position sizes on, not our market value.

Basing your position sizes off true equity has another advantage to it. If you trade any security, you will always have "gap risk." Gap risk, or "skid," is when a security "gaps" below your stop-loss point.

There's not a whole we can do to mitigate gap risk. I employ the above true equity rules as one method to blunt the impact of gap risk on my open positions. (Owning exchange-traded funds (ETFs) in lieu of common stock is one way to dramatically reduce the impact of "gap" risk.)

I've had stocks that were profitable based on market value, and at breakeven based on my stop-loss price, that have gapped right through my stop point to turn a winner into a loser.