True Equity vs. Market Equity

Everybody has a different level of expectations and commitment when it comes to managing their own money. If you are a real student of the game, then what I'm about to share with you will absolutely change the way you quantify risk throughout your investment portfolios.

Investors are becoming much more sophisticated than they had been in the past, and we're seeing more and more non-professional traders bringing real "best practices" risk management to their trading.

One of the most important best practices (and the one I harp on the most) is governing your position size by your stop-loss point. That is, selecting a maximum amount of money (typically based upon a percentage of total portfolio value) you are willing to lose on a single trade, should your stops get hit.

Most hedge funds won't risk more than 1% to 2% of their equity on a trade. This means that, if their stop gets hit, they only lose 1%-2% of their portfolio value. It does not mean that they only invest 2% of their portfolio value at a time. For information on this strategy, visit this link.

This method of position sizing is based upon only risking a set percentage of your total account value. What I want to do today is share with you a big pitfall to avoid when using this approach.

What's Your Portfolio Really Worth?

When new investors learn of the position sizing technique, they immediately set about basing their percentage of risk against their total account market value.

If your total account is just cash or cash equivalents, then that's fine. If it's not, meaning that you're basing your equity on the market value of the stocks and commodities that you own, that's a mistake and I'll explain why.

Let's say you have a $9,800 portfolio, and you have seven different trades on and 100 shares of each stock. For simplicity's sake, let's also assume the following:

Share Stop Current Market
Amount Price Price Value

100 Stock A $12 $14 $1,400
100 Stock B $12 $14 $1,400
100 Stock C $12 $14 $1,400
100 Stock D $12 $14 $1,400
100 Stock E $12 $14 $1,400
100 Stock F $12 $14 $1,400
100 Stock G $12 $14 $1,400
= $9,800 TOTAL EQUITY

This means that any positions that you initiated off the 2% of $9,800 in equity would now represent a risk to your portfolio of 2.33%.

That a 16% increase in risk to principal!

That doesn't sound like a lot with the small numbers I've used in this example but, as your portfolio grows, the impact could be for huge dollars.

The solution is to value your holdings based upon their stop-loss price, not their market price, and basing all new purchases off that discounted valuation.

How Much Do You Really Have at Risk?

By calculating your equity based upon pricing your holdings as if they were selling at your stop price, you create a much more robust risk model for your portfolio. The reason why you should consider using this approach is because you don't want exponential risk exploding through your portfolio if your trades get stopped out.

I call this "true equity" vs. "market equity."

"True" equity is always what you would have if every trade were stopped out. "Market" equity is the equity you have based upon your current market value.

Market equity is always in flux; your true equity adjusts higher or lower as you raise or lower your stop prices.

So if we use the fictional $9,800 account above, you are risking 2% of total portfolio value per trade, or $196. To apply the true equity value rules, we have to remember that the 2% risk parameter is on a sliding scale based upon the cash in your account and the "stop" value of any open positions.

So, while your first trade may allow you to risk $196, your other trades may not. It will depend upon the most current value of your "true" equity.

Using the above example of the seven trades, we would value each stock not at its market value of $14 but rather at its stop-loss value of $12. Any new position would be based off a true equity value of $8,400, not the market value of $9,800.

Guard Against 'Gap Risk'

Let me go over it again: We work out "true" equity by valuing our holdings as if they were trading at their stop prices, plus any cash or cash equivalents we hold in the portfolio. The number that we get is the number we use to base our position sizes on, not our market value.

Basing your position sizes off true equity has another advantage to it. If you trade any security, you will always have "gap" risk. Gap risk, or "skid," is when a security "gaps" below your stop-loss point.

There's not a whole we can do to mitigate gap risk. I employ the above true equity rules as one method to blunt the impact of gap risk on my open positions. (Owning Exchange-Traded Funds in lieu of common stock is one way to dramatically reduce the impact of "gap" risk.)

I've had stocks that were profitable based upon market value, and at breakeven based upon my stop-loss price, that have gapped right through my stop point to turn a winner into a loser.

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 bucks 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 above example, we used seven trades, with each trade risking approximately 2% of our account value (based upon 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 upon valuing your holdings at their stop-loss price, not their market price.

The number you choose is going to be based upon 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.