The 6% rule - protection from piranhas

As markets go through stages, rallies give way to declines or trading ranges. Your style of trading may be in tune with the current market stage or out of tune with it. This is why you need to protect yourself from the possibility of a series of losing trades damaging your account.

You may follow the 2% Rule, and even reduce it to 1%. Still, when losses begin to pile up, your account may begin to sink. The natural human tendency is to push harder when things go badly and put on more trades. In fact, a much better response is to step back and take some time off. The 6% Rule forces you to do just that, by capping the maximum monthly loss in your account.

The 6% Rule requires you to stop trading for the rest of the month after your cumulative loss for that month reaches 6% of your account equity.

Every good trade must begin with this money management question—does the 6% Rule allow me to trade? You know how much you have already lost during the month. You also know how much money you have exposed to the risk of loss in your open trades. Now add up the two and ask—do I have enough available risk left in my account to put on another trade?

If your losses for the current month plus your risk on existing trades expose you to a total risk of 6% of your account equity, you may not put on another trade. When I taught the high school class, risking 1% per trade, the 6% Rule meant we could never have more than six open positions at any given time. The class traded very carefully and never hit the 6% limit.

The 6% Rule

Most traders on a losing streak keep trying to trade their way out of a hole. Losers often think that a successful trade is just around the corner. They keep putting on more and bigger trades, digging themselves ever deeper holes. The sensible thing to do would be to reduce your trading size and then stop and review your system. A trader keeps sharks at bay with the 2% Rule, but still needs protection from the piranhas. The 6% Rule will save you from being nibbled to death.

Whenever the value your account dips 6% below its closing value at the end of last month, stop trading for the rest of this month.

Calculate your equity each day, including cash, cash equivalents, and current market value of all open positions in your account. Stop trading as soon as your equity dips 6% below where it stood on the last day of the previous month. Close all positions that may still be open and spend the rest of the month on the sidelines. Continue to monitor the markets, keep track of your favorite stocks and indicators, paper trade if you wish. Review your trading system.

You may have more than three positions at once if you risk less than 2% per trade. If you risk only 1% of your account equity, you may open 6 positions before maxing out at the 6% limit. The 6% Rule protects your equity, based on last month’s closing value, not taking into account any additional profits you may have made this month.

Whenever you do well, and the value of your account rises by the end of the month, the 6% Rule will allow you to trade a bigger size the following month. If you do poorly and the size of your account shrinks, it will reduce your trading size the next month. The 6% Rule encourages you to increase your size when you’re on a winning streak and stop trading early in a losing streak.

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

positions at any given time. The class traded very carefully and never hit the 6% limit.

The 2% Rule and the 6% Rule provide guidelines for pyramiding— adding to winning positions. If the stock you bought rallies, you can move your stop above breakeven and then you may buy more of the same stock. You must handle each addition as a separate trade and make sure the risk of the new position is no more than 2% of your account equity and your total account risk stays under 6%.

Most traders go through emotional swings, becoming elated at the highs, gloomy at the lows, and losing money to sharks and piranhas across the board. If you want to be a successful trader, the 2% and the 6% Rules will convert your good intentions into the reality of safer trading.

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