Money Management: The 2 % Rule
A general rule for momentum traders is to never risk more than 2 percent of your capital on any one trade. This rule may not be suitable for long-term traders who enjoy higher risk-reward ratios but lower success rates.
The 2 percent rule is a basic principle of risk management. Even if the odds are stacked in your favor, it is inadvisable to risk a large portion of your capital on a single trade.
Larry Hite, in Jack Schwager's Market Wizards (1989), mentions two lessons learned from a friend:
1.Never bet your lifestyle -- never risk a large chunk of your capital on single trade; and
2. Always know what the worst possible outcome is.
Mr. Hite goes on describe his 1 percent rule which he applies to a wide range of markets. This has since been adapted by short-term traders as the 2 percent rule:
The 2 Percent Rule: Never risk more than 2 percent of your capital on any one stock.
This means that a run of 10 consecutive losses would only consume 20%
to Apply the 2 % Rule
1.Calculate 2 percent of your trading capital: your Capital at Risk
2.Deduct brokerage on the buy and sell to arrive at your Maximum Permissible Risk
3.Calculate your Risk per Share:
Deduct your stop-loss from the buy price and add a provision for slippage (not all stops are executed at the actual limit). For a short trade, the procedure is reversed: deduct the buy price from the stop-loss before adding slippage.
The Maximum Number of Shares is then calculated by dividing your Maximum Permissible Risk by the Risk per Share.
Trading capital is $25,000 and your brokerage costs are fixed at $20 per trade.
1.Your Capital at Risk is: $25,000 * 2 percent = $500 per trade.
2. Deduct brokerage, on the buy and sell, and your Maximum Permissible Risk is: $500 - (2 * $20) = $440
3. Calculate your Risk per Share:
If a stock is priced at $10.00 and you want to place a stop-loss at $9.50, then your risk is 50 cents per share.
Add slippage of say 25 cents and your Risk per Share increases to 75 cents per share.
The Maximum Number of Shares that you can buy is therefore: $440 / $0.75 = 586 shares (at a cost of $5860)
Take a Quick test
You receive an alert idea to buy AAPL at $96. Your capital is $50,000 and brokerage is reduced to $25 per trade. How many shares of $96.00 can you buy if you place your stop loss at $95? Apply the 2 percent rule.
Remember to allow for brokerage, on the buy and sell, and slippage (of say 25 cents/share).
The Maximum Number of Shares that you can buy is therefore __
Trading Options, 2% Rule
When trading options I also use the 2% rule, its much simple, if you have a 50.000 account ($50.000 X 2% = $1000 on each trade) by using this simple rule on 10 trades you only expose 20% of your account, I usually try to only have 5 to 8 trades open so my risk management is always less than 20%.