The 2 % rule
Is it true that we have to use this rule if we want to trade the financial markets?
As usual, it depends on who you are asking to. It is not the same someone who makes three trades per year than someone who makes three trades per day. The one who does day trading should be stricter and never risk more than 1 or 2% in each trade.
Trading 2 percent rule
In general, the famous saying that you should not risk more than 2% of your capital in each trade is quite sensible. It is not the fact that 2% is a lot or not.
As I said, it will depend on the case. If someone bets 2% per trade 30 times per day, I would say it will not be too long before he loses his entire account (the more day trading you do the more rapidly you will lose).
Although someone who makes two trades per week may afford to bet 2% and stay longer in the game. In the case that things do not go well after some months, it is very likely that we will still have some capital left and therefore will be able to start a new strategy.
For example, if I trade two times per week doing swing or trend trading with a lot patience, after one year, we will have traded something like 100 times. If we risk 2% each time, have a winning ratio of 2 to 1, and win 35 times we will be close to having a 0% profit in the year.
In this example, we can see how doing normal trading; we are still alive after one year. And that is very important if we still want to be alive in the world of trading.
What would happen if we risked 10% each time?
Most likely you will go bankrupt. We would have lost (do not forget to add commissions and slippage) 50% instead of 0 in the last example.
It is where compound interest comes into play.
Trading too much
If you want to be successful trading a lot, you will have to be right many more times than you are wrong.
If you risk 10% each trade, you have to win ten times to cover 9 losses (for a winning ratio of 1 to 1). Each failure eats 1% of your account. This “cost” will be very important after many trades.
It happens a lot in binary options, where you can open an account with 500€ and where the minimum trade is usually 25. Then you start doing day trading (actually, “hour or minute trading”) and lose your account in a few sessions. The fact that the binary payouts are hardly higher than 0,85 to 1 make it very hard to win there (in the long run, I say almost impossible).
Then, the sane path is to do moderate trading; risking not too much and not being greedy.
We should learn little by little, like all things in life.
Crazy trading position size
Some years ago, I tried to do day trading risking a lot in some of my accounts (those crazy years), thinking that my paper profits of 50% monthly return, would make me rich in a short time. What an easy thing is to do paper trading or using metatrader testing. But in real life things are different, and the real costs and conditions differ significantly; not to mention the psychological factor.
Well, it took me just a matter of few months to burn those accounts. Almost all I gained doing swing and medium term trading was lost.
I tried many markets – ES, CL, Gold, Natural Gas, €$, Cable, Rusell2000, €JPY, USDJPY – and different strategies, but they did not work.
I remember Jesse Livermore saying that he did not understand how others think of going rich betting small. And I thought that it was right, so if I had a good day trading strategy betting 2% of my account each trade, why not trade 6%. By doing so, I would get 1 million bucks quickly and be a great trader. But, reality is hard, and the lesson was learned the hard way.
Some advice for your money management in the markets:
- Always use stop loss orders. Always.
- Use a strategy that you have studied very well.
- Never risk more than 2% of you account in each trade (1% even better).
- Never risk more than 6% of your account at the same time in different trades. Although novice traders should lower that amount significantly.
- Always trade with money you can afford to lose. Never risk your son´s savings.
- Never ask for borrowed money for trading.
- Your trading account should not be an important part of your savings. You should not risk more than 10 or 20% of your capital; above all novice traders.
The devastating Drawdowns.
You have to have a lot of discipline when a bad streak comes. We should never – despite temptation – do martingale, or betting the same amount loss after loss. That is so because as we keep losing our account size diminishes and if we do not change the size of our trading, we may get into serious trouble.
If I bet 2% of my account and I lose, the next trade I should bet 2% of the account again. If I bet the same size as before, I would risk 2.04%. We should never allow ourselves to break that rule. Discipline is the key.
Money management and brokers
It is true that this mentality of applying strict money management is not very popular with the brokerage industry marketing.
When brokers offer leverage of 400 to 1 or 50 to 1, they are looking for day traders. So we should run away from that sort of marketing and ideas.
20 or 10 to 1 is more than enough leverage for an experienced trader, and even less when we trade the volatile stock markets, where a stock may rise 200% in a few years easily.
Money management forex
In the forex markets, we will hardly see 200% bull markets, being 20% moves more common. But that is another story.
What I want to say is that with the 2% rule we can trade stocks doing swing or trend trading without the need of big leverage. And that is the way we should trade. With time comes experience.
100 to 1 leverage, and betting 8% of your account doing day trading? Bad idea.
Mind you, in four months a broker gets as many commissions from a day trader than from a swing trader in 4 years. The fact is that most of the forex and CFDs brokers are market makers, and they win when you lose. They will be very happy if you keep losing doing day trading, and more than 99% of traders lose in the long run doing day trading. So do yourself a favor: stop doing day trading and apply sound money management.