As a child, many of us have endured the arduous labor that is chores. While all of us have done the dishes and cleaned our rooms, let’s admit it… we were always a little envious of our friends who received pocket money. (Trading makes up for it though, so it’s all good :)) Imagine your friend, king of the playground and loaded with $100. Devastated, he loses $50 by accident. Now consider his dad, who likely earns a couple of thousands per month. If he lost the same $50 bill, it would certainly hurt his pride but not his wallet, as much as his young son’s. If you could choose to be in the son or father’s position, which one would you choose? To lose half of your earnings or a minute fraction? This form of decision making is analogous to that of a trader’s. In this post, we will be learning about trading size in your portfolio.
One of the toughest things in trading or investing is figuring out the size of each trade. How much of your capital should be deployed in the markets and how much do you hold in cash? Let’s take a hypothetical portfolio of $10,000. If you have $10,000 in your trading account, how would you allocate this $10,000 in markets to make your money work for you?
Well, you could pick your one favorite stock (selection made on criteria that suits you) and buy every stock possible for the entire $10,000 and hope that the stock goes up in value and you profit from it. Most traders who start fresh are inclined to do this. While this is an easy way to execute, it’s neither prudent nor profitable to put all of your eggs in one basket. What do you think would happen if the stock took a 20% hit and your portfolio value falls to $8000? You can of course wait for the stock to rally to get back to your initial investment of $10,000. But just how easy is it for the stock to move up in terms of it’s current value so that you can break even? If the stock falls 20% in value, it needs to gain 25% from that point for you to make a profit. If the stock falls 50% then it needs to gain 100% (or literally double it’s value) for you to breakeven. The table and chart listed below shows the non-linear relationship between the gains need after a steep drop for your portfolio to recover:
Alternatively, you could spread your risk and allocate this $10,000 across several different stocks in a manner that exposure of risk to your portfolio is spread across these different stocks. For example, we could allocate $250 per trade/investment and buy or sell 15 to 20 stocks/options. This would be a bit more diversified compared to the previous example but if all the stocks selected are highly correlated to each other, then the impact of the market move in a direction would have same impact as if the portfolio had just one stock as in previous example.
So, a better way of portfolio allocation would be is to add some diversification to your portfolio in terms of having some long positions, some short positions, having a mix of stocks, ETFs, commodities, options that have low correlation between each other. Advanced traders would add diversification in terms of strategies so at that one can benefit from the changes in volatility or direction or time.
Personally, in this extremely low IV environment I'd like to keep 50% of my capital in cash and deploy the other 50% in the market, diversifying it through various underlyings and strategies. The trick is to diversify as much as possible and trade small, but trade often, as TastyTrade would say.
Stay tuned for more posts from NishaTrades!
Ninteen year-old trader, future connoisseur of options.
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