The rule roughly states: Risk a maximum of 2% of your trading capital on any one trade. This way you can make 100 losses in a row and still have some money left.
So if your trading account is $50,000, you allocate $1000 to each trade. If your account is $100,000, you allocate $2000. So if you lose on that trade you are only risking a relatively small amount. You might have many trades open at any one time but by risking only $2000 to each trade then you are not going to lose all your money (unless your trading plan is disastrously faulted !) If you are making consistent losses then it is best to step out of the market and review what you are doing wrong. Is the volatility too high? Is the stock you are trading too illiquid? This should all be part of your overall trading plan.
The question the reader puts relates to the fact that when he/she utilises the 2% rule to any one trade, it seems strange to leave so much of the trading capital un-utilised. The temptation for new traders with, for example $50,000, is to make a trade allocation of $10,000 on a trade they think looks good, or fulfils their criteria. If you do this and the trade takes a wrong turn the maximum loss is a much larger percentage of your account, even if you are placing stop losses and especially in the kind of volatile market we are currently experiencing. By allocating only 2% on any one trade, you may have several trades open and be in a position to move on a new one if you see it arise. Once again though, you should have a rule that limits the number of open positions you will have. A good number is six open positions.
The good news is that as your account increases from profitable and well managed trades, your position size increases but the risk in percentage terms stays the same. It is my experience that few traders have the discipline to follow the 2% rule (and I have seen it described as the 2.5% rule), but you can bet London to a brick, that the trader who adopts this rule, with the right strategy for managing successful positions, will be successful and build a good business being a long term trader.
Short cuts just don’t work and by putting pressure on your account with too large a position, you put pressure on yourself and make mistakes. The market will do what it does and we, as traders, must adapt our personalities to it. It will not adapt to us. The 2% Rule is a tool that helps take at least one personal factor out of the equation so that we are less likely to make human mistakes.
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Here is an example:
Account Value: $100,000
2% Trade Allocation: $2000
$2,000 divided by $1.03 Heron Resources HRR = 1941 shares in HRR
Stock moves HIGHER to $1.50 target: 1941 x $1.50 = $2911 for a profit of $911
Account Value now $100,911
Stock moves LOWER to $0.85 and Stopped Out with a $291 loss
Account Value now $99,709
Disclaimers: The views expressed in this article is not intended as general advice.