Week 5: Risk Before Strategy

Risk is taught here, before Swing Trading and Day Trading, deliberately: a position-sizing rule and a stop don’t depend on which style produced the trade. This lecture covers drawdowns, stop placement, position sizing and expected value as the risk toolkit every later strategy lecture assumes is already in place.

The question this week answers#

Why does this course teach risk management before teaching any actual trading style?

By the end of this lecture#

• explain what a drawdown does to the gain needed to recover from it
• distinguish a stop from an invalidation
• calculate a position size from account size, risk tolerance and stop distance
• calculate the expected value of a simulated trading plan

Key ideas#

A drawdown is a decline from a peak account value. Drawdowns are asymmetric: losing a given percentage requires a larger percentage gain to get back to even, which is exactly what the numbers below show. That asymmetry compounds across a sequence of losses, not just one — a string of losing trades doesn’t erode capital in a straight line, it erodes the base the next loss is measured against, which is why a small account can survive several ordinary losing trades and still be one more away from a drawdown it can’t recover from. Position sizing exists specifically to keep any single loss, or a bad run of them, away from that point — what’s sometimes called risk of ruin.

A stop is a price at which a position is closed to limit further loss. An invalidation is the reason the original idea is wrong — the stop price is usually set at or near the invalidation level, but they are conceptually different: a stop is where you exit, an invalidation is why. From this week on, this course describes any strategy using six explicit parts: the observation (what was noticed), the assumption (what it’s taken to imply), the entry (when a position is opened), the invalidation (what would prove the idea wrong), the risk (how much is risked and how position size was set), and the exit (what closes the position, win or lose).

Position sizing answers “how many shares” using the account and the stop, not a gut feeling. Expected value (EV) combines win rate and average win/loss size into a single number describing whether a plan is profitable on average — a plan can win more often than it loses and still have negative EV, or the reverse, depending on the size of wins versus losses.

A worked example#

A simulated $10,000 account loses 50% in a bad stretch, down to $5,000. To get back to $10,000, that $5,000 now needs to grow by 100%, not by the 50% that was lost — the same percentage loss and gain are not mirror images of each other. Five consecutive 10% losses compound to the same place: each 10% is taken off a smaller base than the last, so the account ends near $5,905, not $5,000 — smaller individual losses, reached faster than a single number would suggest, and every one of them makes the next loss proportionally more expensive to recover from.

The numbers#

Position sizing. Risking 1% of a $10,000 account on a trade means risking:

10,000 × 0.01 = $100

If the entry is $48 and the invalidation-based stop is $45, the stop distance is $3 per share. Position size:

100 ÷ 3 = 33.3 → 33 shares

(rounded down, so the actual risk is $99, not $100).

Expected value. A simulated plan wins 40% of the time for an average $150, and loses 60% of the time for an average $80:

EV = (0.40 × 150) − (0.60 × 80) = 60 − 48 = $12

positive, on average, per trade — even though the plan loses more often than it wins. Flip the numbers (40% win rate, average win $80, average loss $150) and the same win rate produces a negative EV of (0.40 × 80) − (0.60 × 150) = 32 − 90 = −$58 per trade. Win rate alone says almost nothing about whether a plan is worth trading.

What a diagram would show#

A risk/reward calculation diagram: a single horizontal bar split into a risk segment (entry to stop) and a reward segment (entry to target), with the 1% account-risk-to-position-size arithmetic labelled directly on it, so the size calculation and the visual proportion of risk to reward sit in the same picture.

Try it yourself#

The takeaway#

Position size and stops don’t depend on which trading style produced the idea — they depend on account size and the distance to the point that proves the idea wrong. The reason to get that right isn’t tidiness: it’s that drawdown asymmetry and compounding losses turn an undersized position, or a bad run of them, into risk of ruin. Everything Weeks 6 and 7 do with entries and charts sits on top of this risk toolkit; none of it works without it.