Every professional risk manager focuses on two things: how much to bet on any single idea, and how to protect against catastrophic outcomes. Position sizing and hedging are the disciplines that keep you in the game long enough for your edge (if you have one) to play out. Without them, even correct views can lead to ruin.
The 2% rule: never risk more than 2% of your total portfolio on a single trade. "Risk" means your stop-loss distance — if you'd sell at a 10% loss, your position size is limited so that 10% loss equals 2% of total capital.
You can be wrong 50 consecutive times before losing all your capital. That gives your strategy room to prove itself without ruin.
The Kelly Criterion calculates the optimal fraction of capital to allocate to maximise long-run growth: f = (bp − q) ÷ b, where b = net odds (profit ÷ stake), p = probability of winning, q = probability of losing. A strategy with a 55% win rate and 1:1 payoff: f = (1 × 0.55 − 0.45) ÷ 1 = 10% of capital. Full Kelly is mathematically optimal but psychologically brutal — most professionals use half-Kelly (5%) to reduce variance at acceptable growth reduction.
A protective put is buying a put option on an asset you own, giving you the right to sell it at the strike price regardless of how far it falls. It's portfolio insurance — you pay a premium (the option cost) for a guaranteed floor.
The cost of hedging: insurance costs money. A fully hedged portfolio earns the risk-free rate minus the hedge cost — by definition. The goal isn't to hedge everything but to hedge the specific risks that could cause permanent impairment, while accepting the risks you're genuinely compensated for. Knowing the difference is the entire art of risk management.
Answer questions on hedging & position sizing, earn XP, and challenge your mates to a stock duel.
Download free on iOS →