2% rule to manage your risk in trading

In previous articles, it has been stated that you should aim to trade another day. While, for most people, this seems like the most obvious thing to do, in practice many traders get wiped out too quickly simply because they take on too much risk. The best way in which you can successfully trade another day is to limit the amount of money that you can lose on one trade. Most traders limit their losses to a maximum of 1-2% of their account on one trade. Some even go lower than this, and for higher value accounts it may be more appropriate to risk perhaps only a quarter of a percent. The power of this can be demonstrated in the example below.
Example 1Let us assume that there are two traders – trader A and trader B. Both have an account size of $10,000. Trader A has a rule that they will risk no more than 2% of their account while trader B will risk no more than 10% of their account. Let us also assume that both traders have exactly the same system and enter and exit a stock in exactly the same way. There are 10 trades altogether with equal number of wins and losses. If a trade wins, Trader A gains 2% and Trader B gets 10%. Trader A
Value of Account ($)
Amount of capital risked ($) (2% of value of account)
Result of Trade (Winner or Loser)
Resulting Value of Account ($)
10000
200
LOSE
9800
9800
196
LOSE
9604
9604
192
WIN
9796
9796
196
LOSE
9600
9600
192
WIN
9792
9792
196
LOSE
9596
9596
192
LOSE
9404
9404
188
WIN
9592
9592
192
WIN
9784
9784
196
WIN
9980
Final Value 9980

Trader B
Value of Account ($)
Amount of capital risked ($) (10% of value of account)
Result of Trade (Winner or Loser)
Resulting Value of Account ($)
10000
1000
LOSE
9000
9000
900
LOSE
8100
8100
810
WIN
8910
8910
891
LOSE
8019
8019
802
WIN
8821
8821
882
LOSE
7939
7939
794
LOSE
7145
7145
714
WIN
7859
7859
786
WIN
8645
8645
865
WIN
9510
Final Value 9510

As can be seen in the example above, it does not really matter whether a trader risks 2% or 10% of the account – the final result is almost identical. Trader A has ended up with $9,980 and Trader B has ended up with $9,510. Each trader will lose some money in this example but the final amount is still very similar to one another.
Example 2
However, let us now look at another example. Let us now assume that each trader is on a losing streak and has ended up with 6 losses in a row. Let us now examine how much each trader will lose.
Trader A (2% risk)
Trader B (10% risk)
Trade Outcome
10,000
10,000
Lose
9,800
9,000
Lose
9,604
8,100
Lose
9,412
7,290
Lose
9,224
6,561
Lose
9,039
5,905
Lose
Final Value 8,858
Final Value 5,314

The results show that in total, Trader A has lost 11% of the account while Trader B has lost almost 47% of the account.Trader A has essentially taken a minor flesh wound but Trader B has taken a near mortal wound losing almost half of his account in only 6 trades! The psychological impact of the losses for Trader B can be devastating and may result in clouded judgment and severe stress.
It can be argued that from time to time you will also have a string of gains that may make taking on more risk more acceptable. However, this is not a good idea for the following reasons:
Almost 95% of new traders will lose in the initial years – this makes losing 6 straight trades more probable than winning 6 trades
Making a lot of money in the initial years may severely inflate your ego and make you more liable to take on more and more risk. This is dangerous. The initial years are a time of learning and making mistakes. Do not concentrate on making a lot of money in the first few years; concentrate on becoming a good trader.
There are always opportunities to make money in the market, so if you miss a good move, so what? You can always take the next one! So do not be so eager to make a large amount immediately. Build up your account slowly and learn from the process.