Two Percent Trading Mechanics

Submitted by Marco Palmero on 11 April, 2008 - 08:09

Two Percent Trading Mechanics

So how do you implement your trading money management with two percent risk management strategy? In this post we will be examining two percent trading mechanics, how you use the rule and some clarifications about the rule. We will extend the rule to cover sensible stop loss levels.

Let me repeat the two percent rule which is to: “Limit your risk on any single trade to a maximum of two percent of your trading capital”. That’s two percent of your total trading account in any single trade. Which means as part of your exit strategy you must exit the losing trade as soon as it hits your 2 percent equity level. In obeying your rules with strict discipline will lead you to trading success.

Limit your risk on any single trade to a maximum of two percent of your trading capital.

We need clarify the two percent trading rule, some people misunderstand the rule and think you are only allowed to trade with two percent of your trading capital. But it isn’t the case. The two percent trading rule specifies that you can only risk two percent at any time but it doesn’t restrict you from trading all or part of your trading capital. Say, you have multiple trades and are actively trading 100% of your trading equity. But out of each trade, you will only ever risk two percent of the total value of your equity at any time. And it also doesn’t mean a two percent fall in the total value of your portfolio: the two percent rule applies to each individual trading position and not, for example, an overall two percent drop of your trading portfolio.

Another mechanical aspect about two percent trading that we need to consider is applying sensible stop loss levels. The two percent rule isn’t implemented as rigidly as you would think. Don’t fall into the trap of automatically applying a 2 percent stop loss to every trade. It doesn’t work that way. For a successful trader also considers the technical aspects of the trade and examine the charts of that particular equity and also considers the support and resistance that the charts display. Applying the rule correctly also means that you have to factor in your technical analysis such as areas of support and resistance. What the 2% money management rule tells the trader is if the stops are placed in a logical place or not with respect to the support and resistance levels.

For example, if the stock is trading around $1 and it is quite obvious from looking at the stock charts that there is a support level at around 90 cents. Let’s say for the sake of thi example that by strictly applying the 2 percent rule you are able to place a stop loss at 80 cents. But remember that the support level is obviously 90 cents. The question is: would you rather exit at the obvious logical support level or wait until your mechanical stop loss level of 2% is realized. I would exit if the stock price violates the logical support – what would you do?

Furthermore, what if the stock was trading at $1 but upon calculating your 2% stop loss you were only able to risk up to 95 cents but the logical support was at 90 cents. Would you enter the trade? Strictly applying the 2% rule would mean you would take a pass on that potential trade. What would you do? Keep in mind that stop losses that are located in no specific areas can be easily set off as the stock prices fluctuate with daily volatility between their logical support and resistance levels. It sounds too good to be true, but if you look at daily, weekly or monthly charts, many stocks, if not all, display some sort of pattern in their chart.

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