Don’t Ever Again Lose More Money Than You Want To (Finance Shorties Series #2)

OK, this seems not complicated at all. But, especially as an unexperienced trading dwarf, frequently you lose more money than expected.

If you think about it the right way, this unintended loss can be avoided easily.

Disclaimer: the following content is for informational purposes only and does not constitute financial advice. Do not take any decisions based solely on my writing.

Required Knowledge

Our beloved dwarf Hulrum has read this stop-loss thing last time. As have some of you humans. Well, thank you, what a pleasure! And if you don’t know what a stop-loss is, please skim it at least briefly. The 5 bullet points in the upper section of the mentioned article are most important.

How to ensure that a loss does not get too big

A stop-loss on its own is not enough. It is also important to adjust the position size to your needs.

• Stop-loss: Roughly controls how much money you might lose on one unit of a security if prices go against you.
• Size: The number of securities you buy (or sell, but we’ll stay on long positions only).

That is, your largest loss is stop-loss per unit times position size!

Sounds simple, but please do read on if you feel you’re not sure.

If you intend to risk max. 10 $ (or dwarves’ ickles) per trade — that means, you do not want to lose more than that amount — here is a good way to reach that aim:

1. You set a stop-loss based on some measure, say, 2 % of current price. If the security costs 100 $, you thus risk 2 $ per unit. → Always calculate the risk amount per unit.
2. As mentioned above you intend to lose no more than 10 $ on the trade. Thus you should buy 10 $ / 2 $= 5 securities.
3. Dwarves should not forget to actually set the stop-loss order then.

The following illustration repeats this. Repetition is everything… as is dwarves’ mindset :)

How to determine a proper position size based on a chosen stop-loss.

This is fine, but not all. There is one itsy-bitsy piece of the puzzle left:

How to account for real-world market behaviour

Order execution: As mentioned in the stop-loss article, a desired stop-loss price level is not guaranteed by the order. The sell order turns in to a market order which shall be filled by the next best possible price.

So what should our risk-averse dwarves do? Set a safety factor. This is very common in engineering if exact calculation is not possible or circumstances are unclear. For instance, you could set your size to just 80 % of the calculated position size. In this example it is 4 instead of 5 units bought. This ideally reduces your risk to 4 x 2 $ = 8 $. And if it goes wrong, i.e. the market order is executed worse than expected , you won’t risk (much) more than 10 $.

Fees: Brokerage fees are part of your loss (not of the broker’s, obviously, that’s why the dwock market cave dwarves are so rich). So, remember that every trade actually starts in the negative. You have to open and close a position, so 2x order fees. If one-time fees are 0.50 $ (so 1.00 $ roundtrip = position open+close) in this example, you might want to decrease your size:

(Tolerated risk — Roundtrip fees) / (Risk per unit) = (10 $-1 $) / 2 $ = 4.5 units

… and “with safety factor” you might choose 4 units.

→ Of course, smaller position sizes mean both lower loss and lower gain.

→ Clever dwarves account for all of their fees: commission and spread. Real clever dwarves do this by logging all cash in- and outstreams directly at their dwock market cave cash account. Then they compare these to shown security prices.

That is it. The earthly author hopes that our beloved dwarves now take good care of their ickles. Let’s repeat one last time: What will our tiny friends do when they are speculating at the dwock market cave?

• They set a stop-loss price level, like some percentage below current price. (e. g., “Hulrum thinks that the dwock won’t go 3 % below 50 ickles”)
• They calculate the per-unit risk. (“3 % of 50 ickles is 1.50 ickles”)
• They define their maximum risk amount per trade. (e. g., “Hulrum has 1000 ickles overall and wants to risk 6 % of that = 60 ickles”)
• They determine the position size. (“60 ickles risk minus roundtrip 2x 3 ickles in fees, divided by 1.50 ickles per unit, equals 36 units”)
• They account for worse-than-expected stop-loss execution by a safety factor. (“Let’s reduce the position size to 30 units to be safe”)
• They buy the securities and then set up a stop-loss order. (“Let’s buy the 30 securities (usually limit order). OK, now Hulrum has them in his dwock depot. He then sets up a stop-loss order at the dwock cave dwarves. The order is: Sell these 30 securities if price drops more than 3 % of 50 ickles. So, stop-loss price level is (100%-3%)×50 ickles = 48.5 ickles. Size is 30. Duration is usually very long or unlimited.)

DISCLAIMER: This article presents my own learnings based on studies generated on synthesized (random, i.e., artificial) data which is statistically similar to real-world time series, and personal experience. The content is, thus, purely educational. Past performance is not reliable indicator of future results. The article should not be considered Financial or Legal Advice. Consult a financial professional before making any major financial decisions.