Starting out with the basics
I wanted to start this blog out with some fundamental psychology. But just to make sure everyone is on the same page, I found that I had to begin with some Tharp Fundamentals instead, because without them, you might not understand what I want to say about psychology. With that in mind, here they are:
You should never enter into a trade without knowing your worst case loss and having a stop to get your out at that point. I define this loss to be your worse case loss or your initial risk in the trade. And we can call it 1R for short. For example, you buy a stock at $20 and decide that if it drops 25% to $15, that you will be out. This a 1R risk for you is $5.
The second fundamental is that position sizing (how much) is the key to meeting your objectives in the market. Let's say that you decide to risk 1% of a $50,000 on each trade or $500. In the prior example, your risk per share was $5 and you want your total risk to be no more than $500. If you divided $5 risk per share into your total risk of $500, you would end up with a position size of 100 shares.
Since you are buying 100 shares of a $20 stock, your total investment is $2000, while your total risk is 25% of that (i.e., you have a 25% stop) or $500.
The third fundamental is that you should express all of your profits and losses in terms of your initial risk. I call these R-multiples. Thus, if your initial risk is $500 and you make $5000, then you have a 10R gain. If your initial risk is $500, and you have a $250 loss, then you have a 0.5R loss. Similarly, if you have an initial risk of $500, but you end up with a total loss of $1000, then you have a 2R loss.
Some of you might say, if your initial risk was $500, how could you end up with a $1000 loss. Well, that's easy, the stock gaps against you on bad news, or you make a stupid mistake, like not keeping your stop. But that's another topic.
