What Is The 2% Rule?
Simply put, make sure the loss on any one trade is less than 2% of your total equity.
In the classic book "Market Wizards," one of the famous traders interviews recommends that traders risk no more than 2% of their capital on any one trade. Any amount higher, the expert trader proclaims, is akin to being a cowboy gunslinger.
Although everyone's circ*mstances are different, in general this is a very good rule. Why? Well, risking only 2 percent of one's account per trade makes it very difficult to get wiped out quickly. As most people probably know, most new traders get wiped out in their first year. Keeping each individual loss small is one way to stay in the game, and give your trading method time to produce profits.
Ways To Practice The 2% Trading Rule
So, how can a new trader with limited trading capital respect this 2 percent rule, and still be in the trading game? Basically, there are three ways:
1) Trade e-minis, mini or micro forex lots, or a very small number of shares of stock. The benefit here is that you can participate in the market, without the risk of a full lot size or large amount of shares. The drawback is that your account equity will grow very slowly, and likely you'll get bored and want to trade bigger. But, it is a good way to start building your capital.
2) Trade with very tight stops. On a $10,000 account, 2% would be $200. So, that would be the amount you'd calculate your stop for. The major problem with this method is that the stop point may be so near your entry that even minor random fluctuations will stop you out with a loss. In addition, commissions and spreads now take up a significant portion of this loss amount. A $20 commission leaves you with only $180 in allowable adverse price movement - not good. With tight stops, you might not lose all your account in a few trades, but you probably will over a larger number of trades.
If you go this route, maybe sure to test your strategy properly, and calculate its expectancy.
3) Accumulate more trading capital. Most people wanting to trade hate this one - trust me, I get enough e-mails from people who have $500 or $1,000 and want to trade. I tell them to get more capital, and they get mad. But never once has someone come back and "I ignored your advice, started trading with $500, and am now a millionaire," although I'm sure it can be done (If you do it, please send me your photo, and I can add it to my photos of Bigfoot and the Loch Ness Monster). While you are gathering more capital, you won't be actively trading, but you can still be involved with trading. Research, following the markets, and developing trading methods are all trading activities you can do without actually trading. And what you learn during this time will probably save you thousands of dollars in the long run.
Ways to Avoid Capital Wipe Out
So, how can a new trader with limited trading capital respect this 2 percent rule, and still be in the trading game? Basically, there are three ways:
1) Trade e-minis, mini or micro forex lots, or a very small number of shares of stock. The benefit here is that you can participate in the market, without the risk of a full lot size or large amount of shares. The drawback is that your account equity will grow very slowly, and likely you'll get bored and want to trade bigger. But, it is a good way to start building your capital.
2) Trade with very tight stops. On a $10,000 account, 2% would be $200. So, that would be the amount you'd calculate your stop for. The major problem with this method is that the stop point may be so near your entry that even minor random fluctuations will stop you out with a loss. In addition, commissions and spreads now take up a significant portion of this loss amount. A $20 commission leaves you with only $180 in allowable adverse price movement - not good. With tight stops, you might not lose all your account in a few trades, but you probably will over a larger number of trades.
If you go this route, maybe sure to test your strategy properly, and calculate its expectancy.
3) Accumulate more trading capital. Most people wanting to trade hate this one - trust me, I get enough e-mails from people who have $500 or $1,000 and want to trade. I tell them to get more capital, and they get mad. But never once has someone come back and "I ignored your advice, started trading with $500, and am now a millionaire," although I'm sure it can be done (If you do it, please send me your photo, and I can add it to my photos of Bigfoot and the Loch Ness Monster). While you are gathering more capital, you won't be actively trading, but you can still be involved with trading. Research, following the markets, and developing trading methods are all trading activities you can do without actually trading. And what you learn during this time will probably save you thousands of dollars in the long run.
When famous traders make bold statements like "risk no more than 2% on any one position" chances are you should listen to them. There is a reason they are famous, and most of the rest of us are not.
New Traders Tip
Trade conservatively, and stay in the game. Don't risk too much at first. Make sure to have a stop loss - a dollar or average true range based stop loss.
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About The Author: Kevin Davey is an award winning private futures, forex and commodities trader. He has been trading for over 25 years.Three consecutive years, Kevin achieved over 100% annual returns in a real time, real money, year long trading contest, finishing in first or second place each of those years.
Kevin is the author of the highly acclaimed book "Building Algorithmic Trading Systems: A Trader's Journey From Data Mining to Monte Carlo Simulation to Live Trading" (Wiley 2014). Kevin provides a wealth of trading information at his website: http://www.kjtradingsystems.com
Copyright, Kevin Davey and KJ Trading Systems. All Rights Reserved. Reprint of above article is permitted, as long as the About The Author information is included.
