Taking a look into the trade account, some traders discover that the main damage for the capital has been done by whether one catastrophic loss or a long series of losses. If they would have exited their positions earlier than they would have more money today. Trades dream of profits but when a deal turns against them, they usually become numb like an elk in the headlights. Traders need rules which will force them to get out of the dangerous path in time instead of waiting and hoping for the trend to reverse.
The literate market analysis does not guarantee the victory. The ability to choose perspective deals does not guarantee the profit. Even the deepest understanding of the market will not help if there is no shark protection. We used to watch traders making 20, 30 and even 50 profitable deals in a row, staying in the overall loss as the result. A long series of wins creates an illusion that you have wound keys to the market. And suddenly a catastrophic loss sweeps away all of the profits in one fell swoop and bites into the initial capital.
A good trading strategy would give you an awesome advantage in the long-term perspective. However, the markets contain so many noises that every single deal is not so far from the coin flip. A professional knows that he will end up in profit by the year-end, but if you asked him would he be in profit with this particular deal, he would honestly answer that he does not know. He uses the stop-loss orders to protect his positions from damage.
The technical analysis helps you to identify the level of the defensive stop-loss order for every single asset. Money management rules show the maximum volume for that asset to buy or sell, just not to put your overall account balance under the threat. The main rule is to limit the risk for every single position by the small portion of the capital.
The maximum risk for every particular deal has not to exceed 2% of the account balance. The rule of 2% is related to your trading account only. You must not take in account your personal savings, real estate investments, pension account or small change in your pocket. The trading capital is the money that you have allocated especially for trading, it is your business investment. This amount includes cash, its equivalent and the current cost of all the assets in open positions. The main goal of trading is the profit while the target of the rule of 2% is to help you to survive with losses.
Let’s imagine you have $50000 in your account balance. You decided to purchase XYZ shares which cost $20 currently. Your profit target is the price of $26 per share and your defensive stop-loss order is at the level of $18. How many XYZ shares can you afford yourself to buy? 2% of $50000 is $1000; that’s exactly the maximum acceptable risk for your account. Buying the shares for $20 and placing the stop-loss order at the price of $18, your total risk is equal to 2 dollars per share. If you divide your maximum acceptable risk by the risk for the single share, then you will get the maximum quantity of shares you can buy: $1000/2=500. This is the theoretical maximum. The real top level is much lower in practice as you have to remember about the slippage and the brokerage commissions which must not exceed 2% together with potential losses. Therefore, the maximum acceptable quantity of shares to buy is 400 more likely, not 500.
It is curiously enough to watch a different reaction of newbies on the rule of 2%. Beginners with small accounts think that this limit is too low. Answering the often question about the possibility to enlarge the 2% limit of the rule, we would say that there’s probably no reason to lengthen the rope when you jump upside down in the ‘Tarzan’ attraction.
On the other hand, professionals often say that the level of 2% is too high and they try not to risk that much. One famous investment fund manager said that his plan for the nearest six months is to increase the volume of the deals. He never risked for more than 0.5% of the account balance, and now he is trying to get used for 1% risk! Good traders usually have a lower deal limit than 2%. You already know what is the best side to stand on when the market professionals’ and beginners’ opinions are divided. You should remember that 2% is the absolute maximum, you should not put yourself in the risk by a larger amount.
Once you have found a prospective deal and decided where you should place the logically-based stop-loss order, you should check whether the rule of 2% will have complied with the calculation of standard lot or a single contract. You should cancel the deal if the risk will be higher than that.
You should write down the volume of your trading capital every month-end. If you had $100000 at the beginning of the month, then the Rule of 2% allows you to risk with not more than two thousand dollars for every single position. If the month goes well and your capital grows to $105000, then the two-percent limit for your single deal will be increased to … How much? You should calculate that faster! Remember, a successful trader is able to calculate fast. If you had $105000 in your trading account, the Rule of 2% would allow you to increase the volume for every single deal up to $2100, so you would have a chance to increase the overall number of positions. In the case, if the previous month was not so good and the account balance decreased to $95000, then the maximum allowed risk will be equal to $1900. The rule of 2% gives you more funds when you win, and it tightens the reins when the things aren’t so good; it connects the latest trading results to the maximum allowed trading volume. If you hold several trading accounts, for example, one for shares and one for currencies, then the Rule of 2% must be applied for every account separately.