Profit is often associated with risk, the higher the rate of return, the greater the level of risk. Therefore, in order to maximize the return of their portfolio, traders need to consider and implement capital management methods.
Good capital management will help you get successful buy/sell deals in the financial markets. One of them is the 2% rule, which was suggested by Alexander Elder in his book “New Trading For a Living” that professional traders are now being taught. use.
What is the 2% capital management rule?
The 2% rule means not risking more than 2% of your total capital per trade. This rule originates from the stock market and its content requires investors to calculate 2% of their available trading capital. That’s called capital at risk (CaR). Brokerage fees for buying and selling assets should be factored into the calculation to determine the maximum amount of capital at risk.
For example, if you have $10,000 in your account, the 2% rule limits the maximum risk per trade to $200. This is not the position volume, it is the amount you bet at risk, based on the distance between the entry price and the stop loss price.
Why 2%?
The rule of survival in the financial markets is never to fall into a big loss. Because once you lose big, you have to work very hard and achieve a high rate of return to get back to where you started. If your account loses 50%, you have to double your account to get your investment back. That’s why the 2% rule is so important in financial trading.
If you lose 2%, then a series of 10 consecutive losses will only make you lose 20% of your total account. A 20% loss can easily be rectified with a return of around 30%. This is a possibility that is within the limits of many investors. Although there are no exact rules, a general guideline for choosing a trading system is to have a maximum drawdown ratio that corresponds to the system’s rate of return. If your system has a 20% return, your drawdown should also be around 20%.
Professional traders consider 2% as a maximum that cannot be exceeded. In fact, they trade with much less risk. Even many Day Traders consider the 1% level as a benchmark that should not be broken. If using the 1% rule, it would take 100 consecutive losing trades for them to be wiped out, which is very unlikely. Although day trading easily increases the rate of false trades (when overtrading inevitably increases the failure rate), they only need to make 1 profitable trade 1-1.5% of the total account per trade is able to cover 1 losing trade. That is, they can cover a loss with 1-2 profit orders.
How to apply the 2% rule
Again, the 2% rule requires you to risk less than 2% of your total capital on each trade.
But how much volume in that 2% range exactly should be calculated based on a formula rather than a vague judgment based on feeling.
To apply the 2% rule correctly, you only need 3 steps:
Estimate the maximum amount to risk per trade that you want (never exceed 2% of your total account balance), called number A.
Calculate the difference between the opening price of the position and the stop loss price, called B
Divide “A” by “B” to find the position volume you are allowed to trade
Good luck.