This Van Tharp theory of ‘Reduced Total Equity Model’ can help you become super trader
Equity capital is the basically the amount of money you have in your trading account based on which you decide how much capital to deploy in a trade.
By Karthik Rangappa
Position sizing is all about answering how much capital you will expose to a particular trade given that you have ‘x’ amount of trading capital. One classic position sizing strategy which most people employ is the standard 5 percent rule.
The 5 percent rule does not permit you to risk more than 5 percent of the capital on a given trade. For example, if the capital is Rs 100,000, then they will not risk more Rs 5000 on any single trade.
Irrespective of which position sizing technique you will follow, at some point the technique will require you to estimate your equity capital.
What do I mean by equity capital?
Equity capital is the basically the amount of money you have in your trading account based on which you decide how much capital to deploy in a trade. This may seem very trivial to you at this point. But, allow me to illustrate why this is a tricky task.
Assume you have Rs 500,000 capital and you work with a simple position sizing principle of exposing not more than 10 percent capital to a single trade. Given this, assume you take a position worth Rs 50,000.
Now for the next trade, how much is your equity capital?1) Is it Rs 450,000?
2) Is it still Rs 500,000 considering the fact 50K is deployed in a trade?
3) Should it be Rs 450,000 plus 50K ± the P&L from the trade that exists in the market?
Given that there are numerous possibilities, estimating equity for the trade is not really a straightforward task. Here is one technique that Van Tharp, the father of position sizing talks about in his book on position sizing, which I find quite interesting, it’s called the ‘Reduced Total Equity Model’.
Here is an example to get the help you understand this well. Assuming I have a capital of Rs 500,000/. Further, assume my position sizing strategy allows me to invest not more than 20 percent on a single trade, which is Rs 100,000/- per trade.
I’m looking at the chart of ACC and I decide to go long on ACC futures at 1800 by blocking a margin of approximately Rs.90,000/-, which is well within my position sizing limit of Rs.100,000/-.
I’ve now entered a position and waiting for the market to move. Meanwhile, as per the reduced total equity model, my the capital available for the 2nd trade is –20%*( 500,000 – 90,000)
= Or about 20% of Rs.410,000/-
= Rs. 82,000/-
Note, because of the existing position, the exposure capital has reduced from Rs.100,000 to Rs.82,000/-. Now, assume the stock moves, and ACC jumps by 25 points to 1850. Considering the lot size of 400, I’m now sitting on a paper profit of –400*50
When a trade moves in your favor, the reduced equity model requires you to trail your profits. Hence, I would lock in say 25 points out of 50 point move or in Rupee terms, I want to lock in Rs.10,000 as profits.
This means, for the long ACC position at 1800, I have to now place a stop loss at 1825 and locked in Rs.10,000/- as profits.
I will now add this locked in profits back to the total equity. Hence my total equity now stands at –410,000 +10,000
This means, my new exposure capital will be 20% of the total equity –=20% * 420000
As you notice, the exposure capital has now increased by an additional 2000/-.
I kind of like the reduced total equity model to estimate the total capital available to position size.
This has a twin advantage – helps your position size and also forces you to lock in profits.
If the trade does not move in your favor, then you essentially reduce the margins blocked along with the losses to estimate your capital.Disclaimer: The author is VP, Educational Services, Zerodha. The views and investment tips expressed by investment experts on Moneycontrol are their own and not that of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.