1. Risk vs uncertainty
Frank Knight (1921): Risk is when probabilities are known (a coin flip). Uncertainty is when they are not (next quarter's CPI). Markets give you mostly the latter. Your job is not to predict — it's to size positions so you survive the surprise.
2. Position sizing & the 1-2% rule
Risk no more than 1% of account equity per trade (aggressive: 2%). The formula:
Position size = (Account × Risk %) ÷ (Entry − Stop)
| Account | Risk per trade (1%) | Entry | Stop | Shares |
|---|---|---|---|---|
| $50,000 | $500 | $120 | $110 | 50 |
| $100,000 | $1,000 | $80 | $74 | 166 |
| $250,000 | $2,500 | $45 | $42 | 833 |
3. R-multiples & expectancy
Define R = your dollar risk on the trade. A trade that makes 3× your stop = a +3R win. A loss at the stop = −1R. Expectancy = (Win % × Avg win R) − (Loss % × Avg loss R). A system with 40% wins averaging +3R and 60% losses averaging −1R has expectancy = (0.40×3) − (0.60×1) = +0.60R per trade. Profitable, even though it loses more often than it wins.
4. The math of drawdowns
| Drawdown | Required gain to recover |
|---|---|
| 10% | 11% |
| 20% | 25% |
| 33% | 50% |
| 50% | 100% |
| 75% | 300% |
| 90% | 900% |
The relationship is non-linear. Avoiding the deep loss is mathematically more valuable than catching the big winner.
5. Stops that actually work
- Structural stop — below the most recent swing low / above swing high. Respects price action.
- ATR stop — entry − 2 × Average True Range (14). Adapts to volatility.
- Time stop — exit if price hasn't moved your way within N bars. Frees capital.
- Mental stop only with strict discipline. For most: place the stop in the broker.
Move the stop only in the direction of the trade. Never widen a losing stop ("hope is not a strategy").
6. Kelly criterion
The optimal fraction of capital to bet on a positive-expectancy opportunity:
f* = (bp − q) / b
where b = win-to-loss ratio, p = win probability, q = loss probability (1−p). Real-world traders use half-Kelly or quarter-Kelly because returns are non-stationary and drawdowns under full Kelly are brutal.
Kelly calculator
7. Diversification & correlation
Diversification only helps if assets don't move together. Two stocks with 0.95 correlation barely diversify each other. Build a portfolio with mixed correlations: U.S. equities (VTI), intl (VXUS), bonds (BND), gold (GLD), cash (SGOV). In a 2008-style event correlations spike toward 1 — only cash and Treasuries truly held up.
8. The 7 destructive biases
- Loss aversion — pain of $1 lost ≈ pleasure of $2 gained. Causes early profit-taking + held losers.
- Confirmation bias — seeking only news that supports your position.
- Anchoring — fixating on purchase price ("I'll sell when it gets back to $X").
- Recency bias — extrapolating the last 6 months indefinitely.
- Overconfidence — after a winning streak, sizing up to ruin.
- Herd / FOMO — chasing what's already up.
- Sunk-cost fallacy — averaging down on a thesis that has already broken.
9. Trading journal — the unfair advantage
Log every trade with: date, ticker, thesis (1 sentence), entry, stop, target, position size, R risked, screenshot. After exit add: actual exit, R result, mistakes, lessons. Review monthly. Within 100 trades you'll see your own pattern — and that pattern is where your real edge (or hole) lives.
10. Pre-mortem & post-mortem rituals
- Pre-mortem (before entering): "It is 6 months from now and this trade was a disaster. What happened?" Write 3 plausible answers; let them shape your stop.
- Post-mortem (after every trade): execute even on winners. Wins from bad process eventually feed losses.
- Quarterly review: did I follow my IPS? What rules did I break? What will I add to the journal next quarter?
"You don't have to be smarter than the rest. You have to be more disciplined than the rest." — Warren Buffett