The 2% solution - protection from sharks

The 2% Rule prohibits you from risking more than 2% of your account equity on any single trade.

When beginners first hear about this rule, many misunderstand it. They take it to mean that a person with a $100,000 account may buy only $2,000 worth of a stock. That is completely wrong! This Rule does not limit your position size—it only limits your risk.

Of course, if you are planning to hold your position down to zero, then its maximum size would have to be capped at $2,000. On the other hand, if you do a much more sensible thing and use a stop, your risk per share will decrease, and your permitted size will increase.

• The distance from your entry price to the stop level defines your maximum dollar risk per share.
• The 2% Rule defines your maximum risk for the entire position.
• Knowing the risk per share and the total permitted risk makes it easy to calculate the maximum number of shares you may trade. For example, you may decide to buy a stock at $12.48 and put a stop at $10.98. This means you’ll be risking $1.50 per share. Assuming you have $100,000 in your account, applying the 2% Rule tells you that the maximum permitted risk is $2,000. Dividing this total permitted risk of $2,000 by $1.50 risk per share means you may trade 1,333 shares. You should round this number down to 1,300 or even lower. Keep in mind that your commissions and slippage have to fit under the 2% total risk limit. You may buy a smaller position if you wish, but never go above the 2% limit! We will return to this concept in the chapter on stops and the Iron Triangle.

The 2% Rule

The ability to find good trades does not guarantee success. No amount of research will do you any good unless you protect yourself from the sharks. I’ve seen traders make 20, 30, and (once) even 50 profitable trades in a row, and still end up losing money. When you’re on a winning streak, it’s easy to feel invincible. Then a disastrous loss wipes out all profits and tears into your equity. You need the shark repellent of good money management. The single most important rule is to limit your loss on any trade to a small fraction of your account.

Limit your loss on any trade to 2% of equity in your trading account.

Suppose you’re trading a $50,000 account. You want to buy XYZ stock, currently trading at $20. Your profit target is $26, with a stop at $18. How many shares of XYZ are you allowed to buy? Two percent of $50,000 is $1,000—that is the maximum risk you may accept. Buying at $20 and putting a stop at $18 means you’ll risk $2 per share. Divide the maximum acceptable risk by the risk per share to find how many shares you may buy. Dividing $1,000 by $2 gives you 500 shares. This is the maximum number, in theory. In practice, it has to be lower because you must pay commissions and be prepared to be hit by slippage, all of which must fit under the 2% limit. So, 400 rather than 500 shares are the upper limit for this trade.

Poor beginners often think 2% is too low. Professionals, on the other hand, often say 2% is too high and they try to risk less. Good traders tend to stay well below the 2% limit. Whenever amateurs and professionals are on opposite sides of an argument, you know which side to choose. Try to risk less than 2%—it is simply the maximum permitted level.

Adapted from Come into My Trading Room, by Dr. Alexander Elder,
John Wiley & Sons, Inc., 2002

Two years ago I volunteered to teach a class called “Money and Trading” at a high school near my office. To make the experience more real for the kids, I opened a $40,000 account which we traded in class. I told the kids that if by the end of the school year we lost money, I’d eat the loss. But if we made a profit, I’d donate half of it to their school and divide the other half among the members of the class. Then I laid down the law—the 1% Rule. Since we began trading with $40,000, I told the kids the maximum risk on any trade would be $400. For example, the kids got excited about Nokia and wanted to buy it at $18, with a stop at $16.75 (risking $1.25 per share). The 1% Rule told them we could trade a maximum of 300 shares. As our account grew, the permitted risk grew with it, but it could never exceed 1% of our current capital.

A trader with a larger account may vary the 2% Rule depending on his level of confidence in a trading idea. For example, he may define a small, medium, or large commitment as risking 0.5%, 1%, or 2% of his account. Then he may risk only 0.5% on an average trade, 1% on a more important trade, and reserve the 2% of risk only for the most promising trades.

1 comment:

Eric said...

Great blog!

What happened to the 40k at the end of the year?

It's the best part of the story.....