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Position sizing

Psychology and Risk Management

What to expect
• Position sizing
• illusion of control
• Accepting critisism
• Paralyzed by fear
• Loss is a feedback, not a failure
• The flexible trader
• Focusing on the positive
• Short straddle
• The dynamics of greed
• The herd mentality
• Notes

1.– Gambler’s fallacy

Let’s assume you Position sizing, are looking at the nifty chart. Let us just assume that these are some valid points for now.

  1. Nifty is reached its highest point ever at 10K.
  2. Given that it is a psychological level, many market participants may book profits at this moment.
  3. All-time high suggests there are no points of resistance
  4. Over the past few weeks, Nifty has been on a strong rising trend.
  5. Maybe around these levels, Nifty might consolidate.
  6. Maybe a 2% to 3% correction before the rally keeps going?

Indicates that taking a short position or perhaps buying puts is appropriate. You may do an analysis that is as basic as this or as complex as reviewing time series data and modelling it using cutting-edge statistical or machine learning methods.

Whatever you do, there is no assurance in the markets. You cannot predict the outcome with a single strategy. It’s suggests that the draws in question are reasonably random. Your chances of winning can certainly increase depending on how insightful your analysis is, but there is no guarantee and you must accept that markets are indeed random.

Imagine that you have performed a cutting-edge analysis and that you have just placed a bet on Nifty when the stop loss triggers. You persist and place another transaction, only to be stopped out once more to your dismay. Say the next four deals are repeated in this cycle.

You are confident in the accuracy of your analysis, yet your stop-loss is consistently being hit. What should you do given that you still have funds in your account to place bets, are adamant that your analysis is accurate and the markets will turn around, and still have a healthy appetite for risk?

Which option are you likely to take?

Traders frequently think that when they enter the “next” trade, long streaks will terminate. For instance, although the trader in this instance has suffered 6 losses in a row, his confidence that the 7th deal will be profitable is now very strong. This is referred to as the “Gambler’s fallacy.”

When dealing with random drawings, the likelihood of losing on the seventh transaction is actually the same as it was when you first placed your wager. The likelihood that you will succeed on your subsequent trade does not increase just because you have a string of losses.

Due to the “Gamblers Fallacy,” traders frequently increase their bet quantities without fully understanding the chances. In actuality, the gamblers fallacy destroys your position sizing philosophy and is the main cause of trading account erasure.

Also, this functions on the other side. Imagine being given the opportunity to see six or ten straight wins. Regardless of what you bet, the exchange is in your favour.

Which of the following are you most likely to do now that you are on your eleventh trade?

  1. If you had enough money to stop trading, would you do so?
  2. Would you take a similar amount of risk again?
  3. Would you increase the amount you bet?
  4. Will you play it safe, perhaps safeguard your winnings, and thus place a smaller wager?
  1. It’s likely that you’ll select the fourth choice. You obviously want to keep your gains and avoid giving up everything you have made in the markets, but you would also want to make a trade given your impressive winning streak.

Another instance of the “gamblers fallacy.” You are essentially reducing your position size for the eleventh trade because the results of the first ten trades have such a significant impact on you. In actuality, the chances of this new trade winning or losing are the same as those of the prior 10 wagers.

This may explain why some traders end up generating very little money, despite entering winning trading cycles.

Position sizing is the cure for the “Gambler’s Fallacy.

2. Overcoming trauma

The money we bring to the table is the raw material in the trading industry. How can you make money if you don’t have enough money to trade with? Therefore, in addition to protecting our cash, we must also preserve the earnings we make.

By extending this idea, we may say that if you put too much money at risk on a single deal, you run the risk of losing it all and being left with very little money.

Now, if you are trading with a small amount of capital, each trade you make will seem to be overly risky.

The climb back to where you started will be Herculean task (in terms of capital).

Lets look at this table.

Starting Capital             1,000
DrawdownStarting CapitalEfforts
5%                     9505.3%
10%                     90011.1%
15%                     85017.6%
20%                     80025%
25%                     75033%
30%                     70043%
35%                     65054%
40%                     60067%
45%                     55082%
50%                     500100%
55%                     450122%
60%                     400150%
65%                     350186%
70%                     300233%
75%                     250300%
80%                     200400%
85%                     150567%
90%                     100900%
95%                       501900%

What do you then? You typically take higher risks in the hopes of earning bigger gains, and if the transaction fails, you effectively succumb to the “recovery trauma” phenomenon.

The precise reason you shouldn’t put too much money at risk in any one deal, especially if you have little capital. Remember that if you can manage to stay in the game for a longer period of time, your chances of making good money in the markets increase. In order to stay for a longer period of time, you need to have enough capital, and in order to have enough capital, you need to risk the right amount of money on each trade.

It ultimately comes down to trying to achieve longer-term “consistency” in the markets, and in order to achieve consistency, you must position sizing your trades really effectively.

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