At it's most simplest, that spreadsheet is making two points: 1) your stops need to align with technical levels, not dollar risk levels to allow yourself the ability to sit through normal market fluctuations. If your stop is based on dollar levels that don't align with technical levels, you're basically just being dumb. 2) If your position size is solid, you can make more trades where you get more out of your winners and less of a draw down from your losers. Simply put, your winners that win big more than compensate for your small losers.
For a more in-depth explanation:
- on shares, if you are only willing to risk $1K, if you have a huge position size, your stop is going to be very tight. In the two examples, one is a 1% risk on $100K ($200 entry, $198 stop). The other is a 2.5% risk on a $40K entry, which gives you room to navigate normal market fluctuations. The example has the stock varying in price from $196 to $210. If your stop was $198, you were out for a loss. What this means is that if you were right 50% of the time, you will make money, IF your position size isn't too large. Meaning if in one of the two trades you get taken out at $195, and in the second trade you get $210. You would be -$5 and +$10 for a total of +$5 to make it worthwhile
- on options, this is even more profound where the stop is -25% and -50%. A 25% draw down in options is very normal on a temporary basis and if you can't sit through that, well, you're doing it wrong. A 50% loss ideally lines up with something like a 20 EMA. In this example, if you have one too large position and your stop is 1.5 and the lowest the option got to was 1.3, you took a 25% loss on a position that may have returned 400% (up to $8) if you had been patient. If it never got above 1.3 and your position sizing was small, you lost $0.7 on one smaller trade, but you made $6 on a trade that worked out, for a total return of $3.3 on $4 risked. Following their math, you only need to be right 40% of the time to be profitable
I can tell you that for me personally, I will rarely go above 3% per trade on options. If I do, I have to really believe in the trade because I will not set a too tight stop (side bar, I believe in all of them if I enter, but these are ones I think are bullet proof). I do not give a sh_t if I lose 1%, and if my stop is 50% of that, it's really 0.5%.
If you want to play a larger position size, do it with profits from smaller trades so that your mind is right about it. A really good way to control your risk is verticals. Just saying.
One edit: I am routinely guilty for hitting a profit target and then setting a trailing stop that will hit above my target, but if I had been looser, could have paid bigger. What I am doing now is setting my revised stop at my target level, and then closing the trade when I think the move has finished or my stop is hit at my target. It works ok for me.
