Teeka Tiwari

How Much Do You Really Have at Risk?

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Let me explain that further: Suppose I own the stock at $20, the stock is trading at $22 and my stop is at $20. On a market value approach, I'm up $2, but on a true equity value approach, I'm at even.

On a gap down, that stock could gap open at $18 -- right through my stop. This is a very real risk, especially around earnings time. This is another reason why I base new buys off my true equity rather than market equity. It does a lot to protect my account from market "skid."

Don't Let Overexposure to Risk Leave You in the Cold

You also need to determine how much total equity risk exposure you are willing to assume. In the earlier example, we used seven trades, with each trade risking approximately 2% of our account value (based on the stop-loss price) for an aggregate exposure to the portfolio of 14%.

This means that, if we assume no gap-down moves and that every stock was stopped out, the total portfolio would sustain no more than a 14% loss of principal. Again, your principal capital, or true equity, is based on valuing your holdings at their stop-loss price, not their market price.

The number you choose is going to be based on your own risk tolerance, and I've seen it vary from 10% to 100%. For my own trading, I don't like having more than 15% to 18% total exposure. This means that, if every position I own gets stopped out, my accounts will lose between 15% and 18%.

As your positions appreciate in value, you can raise your stops, which will make available more true equity that you can use to increase your position size.

By the way, I discovered all of these lessons the hard way as I watched risk balloon through past portfolios, blowing my risk assumptions to smithereens. At first I put it down to "bad luck," but that was just an excuse for not digging deeper. It was only when I really examined the systemic impact of each trade that I came to see where I had gotten it wrong.

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