Risk: How much of our portfolio do we want to put at risk? We need to consider what happens when we have a losing position. If we had $1000 and we risked $500 (50%) and lost it, we would have $500 left. In order for us to get back to break even our $500 would have to make another $500 (100%), very difficult. But if we limit each of our position to 1%, a loss can be recovered with only a 1.01% gain.
- If you lose x%, you will need to gain y% to recover from your lost
- -1%, +1.01%
- -2%, +2.04%
- -9%, +9.89%
- up to here the two percentages seem pretty even with a ratio that’s close to 1:1.
- -10%, +11.11%
- -11%, +12.36%
- -12%, +13.64%
- in this zone the gap between the two percentages is more than 1% and growing.
- -13%, +14.94%
- -15%, +17.75%
- -20%, +25%
- -30%, +42.86%
- -50%, +100%
- as the risk amount continue to increase, it becomes increasingly impossible to recover the loss.
We will consider 1 - 9% as safe, 10 - 12% as acceptable, and anything above 13% as dangerous.
Reward: Next we need to consider how much reward we seek to gain. If we wanted to be super safe and risk only 1% of our portfolio on any given position, we would divide our portfolio into 100 seperate lots. With 100 lots we are only risking 1% of our portfolio. With this low risk comes, unfortunantly, low rewards. If we had $100,000, only $1,000 would be put to work while $999,000 would be collecting dust. Even if the $1,000 appreciated 10% that would only increase our total portfolio by $100. On the other extreme if we risk 50% of the portfolio, we would divide our portfolio into 2 lots. This means $50,000 would be going to work for us and a 10% gain would equal a $5,000 gain. The less lots we break our portfolio into, the more effecient and rewarding it becomes. (Unfortunantly, we previously demonstrated why 50% is too much risk).
- If you risk x%, you would have to break your portfolio into y lots
- 1%, 100
- 2%, 50
- 3%, 33
- 4%, 25
- 5%, 20
- 6%, 17
- as we increase our risk by 1%, the number of lots drop at a quick rate. This also means the effeciency increases at a quick rate. We only need to increase our risk by a little and our reward climbs by a lot.
- 7%, 14
- 8%, 13
- 9%, 11
- 10%, 10
- 11%, 9
- 12 - 13%, 8
- 14 - 15%, 7
- 16 - 18%, 6
- 19 - 22%, 5
- in this group we have to increase our risk in order for our lot number to decrease. This means our efficiency is increasing at a slower rate. The correlation between the risk and reward are fair. A little more risk equals a little more reward.
- 23 - 28%, 4
- 29 - 40%, 3
- 41 - 50%, 2
- in this group we need to increase our risk by a lot just to decrease our lot by 1. This means we need to take on a lot more risk for a little reward.
Since this is speculation money (money one can afford to lose), one can afford to be more aggressive. We will consider the first group 100 - 17 lots as too conservative, the second group of 14 - 5 lots as acceptable, and the last group of 4 - 2 as unacceptable because it would give us great rewards but way too much risk.
Balance: So from the risk point of view we want to have 10 - 12% of risk and from the reward point of view we want 14 - 5 lots. 8 - 10 lots satisfy these two conditions. So our initial capital will be divided into 8 lots and gradually increased to 10, and up to a max of 14.
