Risk Management: The 2% Rule for Trading Success

Novice investors will always focus their efforts on achieving the highest number of winning strategies in the market, but it is also important to learn how to manage risk and that's what we're discussing today.

Specifically the 2% rule. It is basic and crucial that the investor and especially traders carry out proper risk management. In the last 20 years, numerous studies have been developed about how much our behaviour affects decision-making and such money management.

2% rule

Among the main conclusions that have been reached are those explained by James Montier. He divides our psychological biases as investors into four types:

  • Biases due to self-deception
  • Biases in information processing
  • Biases as a result of emotional states
  • Biases due to social influence

Some of the most serious mistakes investors made are cutting profits too quickly and not doing so precisely with losses. Trying to re-enter trades over and over again to take revenge motivated by previous failed operations, the adrenaline generated by the market or exclusively seeking the market information most akin to our ideas.

How does the 2% rule work?

2% rule trading

The 2% rule is collected by Alexander Elder in his famous book “Trading for a Living” which has been translated into numerous languages and is considered today as a trading reference. The highlights as listed below.

  • Its implementation and interpretation is very simple: the rule prohibits risking more than 2% of the total capital of your account in a single operation.
  • The 2% rule will try to find the ideal size that your strategy should have
  • To calculate the position size, calculate 2% of the available trading capital. Ensure you factor broker fee and commissions in your calculation to determine the maximum permissible risk of the capital and then divide the maximum risk amount by the stop-loss amount to determine the number of stock/shares you can buy.
  • If forex, take into account the distance between your entry point and the level of stop loss that you use in each operation to determine the trade you can place.
  • It is a maximum indicative level that keeps you from increasing your probability of ruin in the market and that it is advisable to follow at least when you are training and learning advanced management techniques.

Alexander Elder presents a mnemonic resource to quickly relate the three variables that affect risk management, which he named the Iron Triangle.

What is the Iron Triangle?

The Iron Triangle is constructed with three vertices:

  • Vertex A: maximum risk of the operation (that is the budgeted risk) = 2% of the account capital.
  • Vertex B: maximum risk per action (difference between entry and stop).
  • Vertex C: is the number of shares we should buy (A/B).

How to calculate the 2% risk per trade

For example, we consider testing the rule on a demo account that has an initial balance of 50,000 and we decide to trade in Inditex

First step (Vertex A)

  • We calculate the maximum risk we can assume per operation so we would multiply our capital by the maximum allowed risk (50,000 x 0.02= 1000€)

Second step (Vertex B)

  • We calculate the difference between the entry point and the stop point. Let's say the entry point is £29.83 and you have chosen stop-loss is £27.00, therefore the difference is £2.83 (29.83-27.00 = £2.83)
  • At this point it would be interesting to place a mobile stop always at the distance calculated before

Step 3 (Vertex C)

  • It is the division between vertices A and B: The maximum amount risked for your trading account and the margin amount you have between the entry and stop loss of the strategy. Calculate the number of shares we should buy to maintain the maximum risk level allowed (£1,000 / £2.83 = approximately 353 shares)
  • However, it's important to factor the broker fee for buying/selling to the maximum

What % of risk can I use on a daily basis?

Is the 2% rule effective?

It is clear that it will depend in general on your operations, but you can stick to a fixed percentage to risk part of the capital or you can opt for a variable method in which you risk less in times of volatility of the market or falls and allow a higher percentage in the best market years.

The most important thing is that whatever method you use, you always have a monetary control of your investments that does not endanger your financial health and guarantees you many years of trading in the markets.

And you? What percentage of your capital do you risk? You can tell us in the comments and tell us what you think.

Conclusion of the 2% rule

As we can see in a simple way we can manage the risk in our operations always looking to preserve capital and trying to avoid falling into irrecoverable losses.

This rule can be applied with other indicative percentages where we feel comfortable. Like which ones? 1% or 1.5%. Less than 1% wouldn't make much sense and above 2% could be very risky.

Is it a good method? In general terms yes, and even more so if we talk about beginner investors. However, this rule does not reward very good systems that make us earn a lot of money, since we will always risk less capital than due.

On the other hand, if we have losing systems it exposes us more in the market making this rule somewhat inefficient. Since if we regularly lose money, it exposes us more in the market.

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FAQs about the 2% rule of risk management

What is the 2% strategy?

The 2% rule is an investing strategy where investors risk no more than 2% of their capital on any single trade. To implement the 2% rule, the investor must first calculate what is the 2% of their available trading capital.

What is the 50% rule in trading?

The “50% rule” in trading has two interpretations:
1. Unreliable Heuristic: Suggests assets retrace 50-67% of gains/losses before resuming trends. Lacks strong evidence and can be misleading.
2. Technical Analysis: Refers to a 50% retracement level used in Fibonacci analysis, potentially indicating support/resistance zones. Should be used cautiously with other tools.
Remember, neither interpretation offers guaranteed results, and caution is advised when encountering the “50% rule” in trading.

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