Forex Walkthrough

AAA

Trading Rules - Never Risk More Than 2% Per Trade

by Boris Schlossberg and Kathy Lien

Never risk more than 2% per trade. This is the most common - and yet also the most violated - rule in trading and goes a long way toward explaining why most traders lose money. Trading books are littered with stories of traders losing one, two, even five years' worth of profits in a single trade gone terribly wrong. This is the primary reason why the 2% stop-loss rule can never be violated. No matter how certain the trader may be about a particular outcome, the market, as the well known economist John Maynard Keynes, said, "can stay irrational far longer that you can remain solvent." (For more on "stop-loss" read the article The Stop Loss Order - Make Sure You Use It.)

Swinging for the Fences
Most traders begin their trading careers, whether consciously or subconsciously, by visualizing "The Big One" - the one trade that will make them millions and allow them to retire young and live carefree for the rest of their lives. In FX, this fantasy is further reinforced by the folklore of the markets. Who can forget the time that George Soros "broke the Bank of England" by shorting the pound and walked away with a cool $1 billion profit in a single day! But the cold hard truth of the markets is that instead of winning "The Big One", most traders fall victim to a single catastrophic loss that knocks them out of the game forever. (To learn more about George Soros and other great investors, read the Greatest Investors Tutorial.)

Large losses, as the following table demonstrates, are extremely difficult to overcome.

Amount of Equity Loss Amount of Return Necessary to Restore to Original
25% 33%
50% 100%
75% 400%
90% 1000%


Just imagine that you started trading with $1,000 and lost 50%, or $500. It now takes a 100% gain, or a profit of $500, to bring you back to breakeven. A loss of 75% of your equity demands a 400% return - an almost impossible feat - just to bring your account back to its initial level. Getting into this kind of trouble as a trader means that, most likely, you have reached the point of no return and are at risk for blowing your account.

Why the 2% Rule?
The best way to avoid such a fate is to never suffer a large loss. That is why the 2% rule is so important in trading. Losing only 2% per trade means that you would have to sustain 10 consecutive losing trades in a row to lose 20% of your account. Even if you sustained 20 consecutive losses - and you would have to trade extraordinarily badly to hit such a long losing streak - the total drawdown would still leave you with 60% of your capital intact. While that is certainly not a pleasant position to find yourself in, it means that you need to earn 80% to get back to breakeven - a tough goal but far better than the 400% target for the trader who lost 75% of his capital. (to get a better understanding check out Limiting Losses.)

The art of trading is not about winning as much as it is about not losing. By controlling your losses, much like a business that contains its costs, you can withstand the tough market environment and will be ready and able to take advantage of profitable opportunities once they appear. That's why the 2% rule is the one of the most important rules of trading.

Trigger Fundamentally, Enter and Exit Technically


Related Articles
  1. Active Trading Fundamentals

    Limiting Losses

    It is impossible to avoid them completely, but there is a systematic method you can use to control them.
  2. Active Trading

    10 Steps To Building A Winning Trading Plan

    It's impossible to avoid disaster without trading rules - make sure you know how to devise them for yourself.
  3. Active Trading Fundamentals

    Beginner Trading Fundamentals: Limiting Risk

    Managing risk is the most important thing you do as a trader. Here we discuss probability and strategies for limiting trading risk.
  4. Forex Education

    Forex: Money Management Matters

    Currency trading offers far more flexibility than other markets, but long-term success requires discipline in money management.
  5. Forex Education

    Understanding Forex Risk Management

    There's risk in every trade you take, but as long as you can measure risk, you can manage it.
  6. Forex Education

    6 Steps To A Rule-Based Forex Trading System

    Learn to add structure to your trading methods with these six important steps.
  7. Options & Futures

    Money Management Matters In Futures Trading

    Learn how this overlooked area of trading can help improve your gains.
  8. Forex Education

    Forex Trading Rules: Risk Can Be Predetermined; Reward Is Unpredictable

    by Boris Schlossberg and Kathy LienIf there is one inviolable rule in trading, it must be "stick to your stops". Before entering every trade, you must know your pain threshold. This is the best ...
  9. Forex Education

    Position Sizing: The Way To Profit In Forex

    Position sizing will account for the quickest and most magnified returns that a trade can generate.
  10. Active Trading

    Top 4 Mistakes That Cause Futures Traders To Fail

    Learn to keep your losses to a minimum and consistently produce positive results.
RELATED TERMS
  1. 2% Rule

    A trading practice where an investor should concentrate no more ...
  2. At Risk Rules

    Tax laws limiting the amount of losses an investor (usually a ...
  3. Day Trader

    A investor who attempts to profit by making rapid trades intraday. ...
  4. Short-Term Loss

    A capital loss realized on the sale or exchange of a capital ...
  5. Paper Profit (Paper Loss)

    Unrealized capital gain (or capital loss) in an investment. It ...
  6. Loss Psychology

    The emotional aspects associated with investing and the negative ...
RELATED FAQS
  1. How can you lose more money than you invest shorting a stock? If you have no money ...

    The simple answer to this question is that there is no limit to the amount of money you can lose in a short sale. This means ... Read Answer >>
  2. How risky are stop loss orders?

    Understand the purpose and uses of a stop-loss order as a risk management tool for trading and also the risk associated with ... Read Answer >>
  3. What trading strategies help investors withstand a drawdown?

    Understand the concept of drawdown and the importance for traders of having a trading strategy that takes temporary drawdown ... Read Answer >>
  4. How do I place a stop loss order?

    Learn how to place a stop-loss order and how traders use stop orders to either limit potential losses or to protect part ... Read Answer >>
  5. Is it better practice to use a stop order or a limit order?

    Discover whether it is considered best practice to use stop losses or limit orders. Both options have their advantages and ... Read Answer >>
  6. What should I do about my IRA that keeps losing money?

    I have a Roth IRA and it keeps losing money and the investment firm never calls to let me know what's happening. It's ... Read Answer >>
Hot Definitions
  1. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  2. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  4. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  5. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  6. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
Trading Center