Two Percent Risk Management

Submitted by Marco Palmero on 20 March, 2008 - 12:58

Two Percent Risk Management

Good trading is not enough to succeed in the markets. The secret to successful trading is in great money management. The skill of money management is required because the real business of trading is making money with money through controlling risk. And an integral part of great money management is a great risk management strategy. The heart of that strategy is the magic 2 percent. So why two percent?

Two percent risk management is a necessary strategy for trading success. Why? Because of mathematics. This is the problem: when you lose money you’re left with less than what you started with (isn’t that obvious?). Okay, if you lose 10 percent of your account of say $1000, you lose $100 and you’re left with $900. A 10 percent gain from the current trading account will only see you gain $90, leaving you $10 short in getting back to your previous trading equity level (not including brokerage commissions). To get back to $1000 you would need to have an 11.11% return from the next trade. If the cycle of losses continue, the amount of return you need to get back to your original account would get larger and larger.

So the two percent risk management rule states that you must limit your risk on any single trade to a maximum of two percent of your trading capital. For amateur traders, the two percent rule gives leeway for mistakes and gives the amateur trader time in the market to learn and survive for the longer term. For professional traders, the two percent risk management is their margin of error.

The way the two percent risk management rule works is this: if you have $10,000 sitting in the bank – that’s your equity. Two percent of your total equity, or trading capital is $200. So at any time your losses for any trade amount to a $200 you must exit the trade immediately. Applying this rule strictly and with strong discipline will steer you away from any major trading wrecks.