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David is recognized as the leading expert on both MetaStock Professional and profitable trading system design. He earned this title after working at Ord Minnett (one of Australia’s top brokerage firms) and training hundreds of traders at HomeTrader (Australia's leading stock market education company).

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May 06
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Living To Trade Another Day – Why The Professionals Never Risk More Than 2%

In previous articles:

First Steps To Consider Before Trading
Learning To Lose Like An Expert
Common Trading Mistakes

…. 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.

In 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.

The Second Rule Of Money Management – Use The 2% Rule Carefully

In the previous article, I spoke of how important it was to ensure that you had a fixed percentage risk to every trade. While the exact percentage is essentially down to you, I would suggest that for beginner and intermediate traders that this does not exceed more than 2% of your trading float. So, for example, if you have an account worth $10,000, you should not risk more than $200 (i.e. 2%) in any one trade. This rule will enable you to cope with a string of losses that will occur from time to time and not be wiped out as soon you start to trade!

However, there is also the old saying that you should not put all of your eggs in one basket. If the 2% rule is used in isolation, it is entirely possible for you put all of your hard earned cash into one share. This situation can lead to two main problems:

  1. You are entirely at the mercy of the price fluctuation of that one stock – so any news, for example, that causes the stock to gap below your stop loss will cause heavier than anticipated losses.
  2. You could situation where you have an excessively large position in one stock and will not have the funds to purchase another stock for your portfolio if you wanted to.

These situations can be avoided by applying an overarching rule not to put more than a certain percentage of your entire trading float into one share. For smaller accounts, I would suggest not to put more than 25% of your total float into any one trade although this can be down to the individual to decide. For larger accounts, the risk should be smaller – perhaps even 5-10% of the float in any one stock.

Example

You have an account of $10,000 and notice that stock XYZ is an excellent buy and wish to purchase it at the current price of $25 per share. Your money management rules state that you will not place more than 25% of your float into any trade and you have an overall risk tolerance of 2% of your account.

  1. The total amount of stock that you will be able to purchase is going to be $2500 (or 25% of your trading float)
  2. The price per share is $25 and this suggests that you are able to purchase a maximum of 100 shares of stock XYZ
  3. You will not risk more than 2% (i.e. $200) of your total float – this is the equivalent drop in value of your shares to $2300 or a drop of the price to $23 per share.

Now comes the hard part. Your own technical trading system should tell you where to place your stop loss. If your system suggests that the stop loss is above $23, then this is an acceptable trade and you will enter accordingly. On the other hand, if your stop loss is less than $23, this suggests that you will be taking on too much risk and you should abandon the trade.

The example above can be applied to any situation and will save you from entering trades that will involve undertaking too much risk. This is the most important, and the most overlooked, element in any trading system and a mastery of this is essential to your future as a successful trader.