Control your Position Sizing for each Trade

Be aware what the risk of ruin is for your portfolio. For example : If you have a $100,000 portfolio, if you risk $1000
on every trade (and never changed that), then you risk of ruin would be 100 consecutive losing trades (highly improbable, but still possible).

Now imagine we change the trading methodology to only risk 1% of your portfolio on every trade. For example if your portfolio trades down to $80,000 your trade risk automatically would reduce
to $800. If we trade with a 1% trade size having 100 losing consecutive trades would leave you with an account size of $38,490 (obviously very, very bad, but we are still in business). Even
with this conservative 1% trade size methodology you can still trade the account down to $10,000 with 234 consecutive losing trades. (Note: we will not show calculations for these numbers
here, but we may post the simple Excel methodology in later articles).

Be disciplined and trade your capital, not your released losses. If your $100,000 portfolio becomes a $97,000 portfolio, sadly you have want you have – the fact you just lost $3000 (3%) last
month is irrelevant.

Principle : Always size individual trade risk up to a maximum of 1 percent of the overall portfolio size (not a fixed trade size).

No need to Over Diversify

Over diversification does not significantly reduce the overall portfolio risk. Research shows that once you get over 10 stock positions in
a portfolio the impact of the diversification is significantly diminished.

Extreme diversification is a strategy that is used by wealth management divisions to preserve a client’s wealth (typically >$10million) that has already been acquired. It is not a
mechanism to generate returns, and may not be helpful to smaller portfolios. You may also thrash on transaction costs trying to allocate across more stocks and ETFs than is necessary
(especially if you are re-balancing quarterly).

Sector ETF’s are a good way to get instant position diversification to reduce that chance that an individual stock underperforms.

Principle : Always have more than 10 individual stock or ETF holdings in a portfolio (preferably spread across different sectors), but no need to over diversify.

Principle : Using liquid ETF’s for sector exposure can reduce asymmetric individual stock risk

Beware High Correlations between Equity Positions

Without hedging there is also the problem of asset class correlation. Traditional advice based on Modern
Portfolio Theory (MPT) states that diversification will help because when one asset class goes up, the other goes down – however the major problem with this assumption is that is assumes
that the historical correlation between certain the asset classes is always going to be same in the future.

As results show from the financial crisis sometimes these correlations breakdown under high stress
scenarios – “During times of financial crisis all assets tend to become positively correlated, because they all move (down) together. In other words, MPT breaks down precisely when
investors are most in need of protection from risk.” (see assumptions).

For example : take a typical recommended “conservative” asset allocation: 30% bonds/cash, 25%
large cap equity, 20% mid cap growth equity, 10% small cap equity, 15% foreign equity. This is a conservative portfolio recommended by many financial advisors, but it has the major issue that
70% of the portfolio is diversified across many equity themes, but still very highly correlated. For example if the S&P 500 goes down 10%, then it could be fair
to assume that large cap is down 8%, mid cap is down 11%, small cap is down 14% and international is down 15% (educated guesses). In this case the high correlation between equity asset
classes takes away the “safety” of diversification.

Principle : Recognise that diversification across equities is not true diversification, as equity markets globally are tightly correlated. Hedging all equity positions
individually reduces this “catastrophic correlation” risk in major market selloffs, by defining maximum losses in advance.

Some Market Timing is Helpful for Returns

We believe that when you got into your market with the majority of your money (your ultimate cost basis) is one of the single most important determinations of performance, even over
long periods of time.

For example : if you buy an index at 1000 and over 10 years it goes to 5000 (that is a nice 500% return). If however you bought the index at 500 during a huge trading dip, and over 10 years
it still goes to 5000 (that is 1000% return – which is double the 500% return). This is a very simple extreme example, but taking a 50% pricing discount on entry, ended up having a 500%
difference in returns.

Market timing (or trade entry point) for a portfolio is important and arguably more so over investments that will be held for long periods. We don’t pretend to have a crystal ball on
market direction, but we do recognize that historically you can make the best returns after a big market selloff up to 20% (but we would still always hedge).

Principle : Providing the downside risk is hedged, entering long positions on market declines can greatly improve long term portfolio performance.

Hedging Discipline

You have to decide if you are going to hedge every month, even if you know that you are likely to lose on the hedges in the next month. For example, if the market is down 10% for the
month, it is likely that there will be a bounce next month. However you have to weigh that against the possibility that the market continues to sell off.

If you run a hedging strategy for 2 years on one stock, then decide to take off hedges and it continues to sell off 20% that month, that can make it very difficult to recover from (especially
if you decide to start hedging again after the selloff, due to your bad experience). The hedges are there in an attempt to remove the ever present tail risk disaster scenario.

Principle : We typically view hedging as a fully comprehensive insurance policy, and as such we would always have some hedges on each position.

Keep a Trading Diary

Keep a trading diary to keep yourself honest. We do this by blogging, but you can do this privately. It is important to document the exact reasons for you making the initial trade, and any
subsequent trade adjustments.

For example if VLO is trading at 25 on July 3^rd 2012 and you sell an Aug 2012 at strike 26, then the market accelerates through the 26 strike (by July 18^th 2012) with 1
month to expiration. It is very good to record your initial thinking with the trade, because (with obvious hindsight) that was the “wrong” thing to do. However it may have been the
“right” thing to do on July 3^rd, so the trade diary may capture this with an entry like :

• VLO in 7^th up day in a row (so the rally is looking a little bit tired)
• Wanted to capture some premium to offsite the original Dec 2012 put at strike 22 which is losing money.
• Just before holiday July 4^th and markets can tend to make false rally moves faster than usual because of lower trading volume (so this may be a bogus move in the short term)

Later you can see if this is a “wrong” trade made for the “right” reasons, or if you have a consistent problem capping rallies in stocks moving strongly upward because you sell premium too
soon. Just this one insight could save you many dollars a year, not having to buy back calls at higher levels. Look for failure patterns over the years you have been trading, and review your
diary entries. We use the terms “wrong” and “right” deliberately in quotes, because these are only obvious with hindsight.

Over time you will have a very valuable trading diary that you can see how your speculation has (hopefully) improved.

Principle : Always keep a trading diary

Compound Interest

30 Day trading strategies are primarily designed to protect capital gains, and prevent significant losses. However the extreme power of compound interest in dividend paying stocks in a portfolio over a number of years should never be overlooked.

Hedging dividend paying stocks can be one of the safest long term strategies (provided it is done intelligently such that the all the dividend yield isn’t eaten by the hedges). Arguably you
can make very high yield issues “safer” by hedging. This enables you to capture higher returns that you would otherwise consider too “risky” without hedges.

Principle : Portfolio dividend yield is important and compound interest over years is significant.

Principle : Hedging allows you to consider high yield “risky” stocks.