# Understanding 'Risk Management & Trading Psychology'

## 12.1 -Equity capital

We have already discussed some key points about position sizing in the last chapter. Now it is clear why every trading strategy must include position sizing. The position sizing method helps you determine how much equity capital must be exposed for a trade. This chapter will discuss how to position size.

Before we move on, a quick overview. What is position sizing?

The purpose of position sizing is to determine how much capital you can expose to a trade given that you have x amount of trading capital. The standard 5% rule is a classic strategy for sizing position. You cannot risk more than 5% on any trade within the 5% rule. If the capital is Rs.100,000.- then they cannot risk more than Rs.5000/- in any trade.

Here, 5000 represents the trade exposure and 10000 the equity capital. Based on a position sizing strategy or rule, you have decided to invest 5000 per trade.

There are many ways to position your money. This, unfortunately, does not mean that there is a single way to position your money. As a trader, you need to try different strategies and find what works best for you. I will soon discuss a few strategies for sizing positions.

No matter which position sizing method you choose, you will need to estimate your equity capital. We will first discuss how to estimate equity capital, then we'll move on to discussing position sizing.

What does equity capital mean?

Equity capital simply refers to the amount of money in your trading account. This is what you use to decide how much capital you want to invest in a trade. This may seem trivial to you. Let me show you why this is such a difficult task.

Let's say you have Rs.500,000 capital. You work according to the simple principle of position sizing, which is limiting your exposure to one trade to 10%. Assume you have a position of Rs.50,000/-.

How much equity capital do you need to make the next trade?

1. Is it Rs.450,000
2. It is still Rs.500,000, considering that 50K are deployed in a trade.
3. Is it 450,000 plus 50K + the P&L of the trade that is currently in the market?

It is difficult to estimate equity for trades because there are many outcomes and possible outcomes. It is important to estimate the equity capital accurately before we can learn about position sizing concepts.

## 12.2 Estimating Equity Capital

Here's a chance to talk with Van Tharp about the methods he uses for estimating equity capital. These are the best techniques out of all the others. These are the three main techniques, or models, as he calls them.

1. Core Equity model
2. Model of Total Equity
3. Model with reduced total equity

You must subtract the capital that is allocated to trades from your existing capital in the core equity model. As you move up in your positions, your exposure to trades decreases. Let me show you an example: let's say your equity capital is Rs.50,000/= and you use a simple 10% position size formula. You should not expose more than 10% of your capital for a trade. The first trade has an exposure of Rs.5000. Now, the core equity has been reduced to Rs.45000. Take a look at this table.

Image 1

The equity available for the first trade is assumed to be Rs.50,000. Therefore, 10% of the equity is exposed in the first trade, i.e. Rs.5000/-. Core equity requires that you subtract the capital used to trade and rework the core equity model. The core equity now stands at Rs.45000/-. This is the equity available for the 2 and trades.

We again deploy 10% equity for the 2 and trades. That is 10% * 45000 = Rs.4500/+. This amount is deducted to calculate the core equity which is now Rs.40,000. This is also the new equity available for the 3 rd trade.

The 3 rd trade has a capital exposure of Rs.4050, and the new core equity at Rs.36,000. You get the idea.

This is a conservative equity estimation model. As the opportunities increase, you reduce capital allocation. Your 5 th trade, for which your equity exposure is much lower than the rest, may turn out to be a huge winner. Another argument is that 5 th trades could be the worst offenders compared to all the others.

Despite that, I love this model because of its simplicity. You can forget about it once you have committed capital to a trade and you can move on to what's available.

The Total equity model combines all positions in the market with their respective P&Ls and cash balances to calculate the equity. This is illustrated by an example.

Margin Block for Trade 1 = Rs.75,000

P&L for Trade 1 = + Rs.2,000

Margin Blockage for Trade 2 = Rs.115,000

P&L on Trade 2 = + Rs.7000

Margin Blockage for Trade 3 = Rs.55,000

P&L on Trade 1 = Rs.4,000

Total Equity = 50000 + 7000 + 2000 +115000+7500+55000-4000

Rs.300,000.-

As you can see, the total equity model takes into account free cash, margins blocked, and the P&L per trade. If my position sizing strategy recommends a 10% exposure for a new position then I would expose Rs.30,000/- to a new trade. I wouldn't open a new trade if my account balance is not sufficient to allow me to take on this position. To take over a position, I would wait to close an existing one.

This model takes into account a live position as well as its P&L when estimating equity. It is a bit risky. This equity estimation model is not something I like. This is a bit like counting chickens before they hatch.

The 3 rd method to estimate equity is my favorite. This model is known as the'Reduced Equity Model'.

This model combines both the best parts of the total equity model and core equity model. This model reduces capital allocation to trades (similar to core stock model) while also including the P&L for trades already in place (similarity to total equity model). The P&L only applies to locked-in profits.

Let me Show this with an example to explain this. Let's say I have Rs.500,000/- capital.Let's say that I have a position sizing strategy which allows me to invest less than 20% in one trade. This works out to Rs.100,000.

I look at the chart for ACC and decide to take a position in ACC futures at 1800. I block a margin of around Rs.90,000. This is within my position sizing limit at Rs.100,000.

I have now placed myself in a position and am waiting for the market's movement. In the meantime, according to the reduced total equity model my capital available for the 2 and trades is -

20%* (500,000 - 90,000.

About 20% of Rs.410,000/=

Rs. 82,000/-

The exposure capital has been reduced from Rs.100,000. to Rs.82,000/. It works exactly the same as the core equity capital model up to this point.

Let's say the stock moves and the ACC jumps 25 points to 1850. Given the 400-lot size, I now have a paper profit.

400*50

= Rs.20,000/ -

I would place a trailing stop loss and lock in at least 25 points from 50 move or, in Rupee terms, I want to lock up Rs.10,000 of profits.

For the long ACC position at 1800 I must now place a stop-loss at 1825 and lock in Rs.10,000/– as profits.

This locked-in profit will be added to my total equity. My total equity now stands as -

410,000 +10,000

420,000/-

My new exposure capital will equal 20% of my total equity.

=20% - 420000

Rs.84,000/ -

As you can see, the exposure capital has increased by 2000/-.

The reduced total equity model is what I like to use to calculate the capital available for a position size. This technique is good if one follows it. It forces you to use basic stop loss principles.

Anyway, I would like to end this chapter. We will be discussing one of the methods mentioned above to estimate equity, and a few techniques for sizing positions in the next chapter.

## To Summarize

1. For position sizing, it is important to estimate equity capital
2. Core equity model subtracts capital allocated to trades and recalculates capital available
3. To estimate equity capital, you will need to add the total equity model's free cash, blocked margins, and the P&L for the positions.
4. The Reduced Total Equity model allows you to add the cash free to the locked-in profits of an existing position