What is the 2% rule and why should all traders know about it?

When deciding to enter a trade the most important decision is determining how much to risk on the trade. The 2% Rule represents the actual percentage of a trader’s capital that he or she is willing to risk on a single trade should it go against them. So a trader with $100,000 capital will risk $2,000 per trade.

The 2% Rule is a concept many traders use, however the exact percentage you choose will be determined by your own trading capital. Traders with $100,000 or greater may use a 1 or 2% Rule, while those with smaller accounts may use a 3 or 4% Rule. Either way, the only way to be successful in the market is to reduce losses when they do occur.

Managing your risk is a key element to being a successful trader. Novice traders are quick to look at how much they could make, yet have no plan for when to cut a loosing trade. Successful traders will have a trading plan that will include a predetermined figure on how much they are willing to risk on each trade such as 2%. Having a set figure will also take the emotion out. Disciplined traders that stick to the 2% Rule will have the benefit of being able to make clear decisive trading decisions. If the trade moves against them by 2% of their trading capital, the position is exited. This is one area novice traders struggle with and end up losing more money than they should- when do you cut a losing trade.

The level of risk per trade, 1 or 2% of your trading capital is kept at a small amount to avoid a string of losses that could wipe out your entire trading capital. Losses are always going to occur, but limiting the losses and preserving your trading capital are vital for staying in the game.

Using the 2% Rule, with $100,000 trading capital, it would take 50 straight losses to wipe out your entire trading capital. You might get a few trades wrong in a row, but you would have to be very unlucky to have 50 wrong trades in a row straight-up. On the other hand, if you risked 25% of your capital per trade, it would only take 4 wrong trades to wipe you out. Even successful traders will have 4 losing trades on occasions.

An example of the 2% Rule: A trader with $100,000 trading capital decides to buy stock XYZ. The trader decides that he wishes to risk 2% – or $2000 – on the trade.

Now that he has determined how much he is risking, he will now need to work out the position size. He could buy $20,000 worth of stock and have it fall 10% before getting out, or he could buy $10,000 worth of stock and have it fall 20%. In each case, he is still only willing to risk $2,000 on the trade.

Should XYZ fall and the position is closed out with a $2,000 loss, the trader will still have $98,000 of trading capital.

Remember to only trade sizes you are comfortable with – the 2% Rule does not allow for market gapping.