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. Forex Education

    5 Foreign Currencies Americans Buy the Most

    Look at which currencies Americans buy the most for travel abroad and remittances, and how the current strength of the dollar is impacting those transactions.
  2. Investing Basics

    Contingent Convertible Bonds: Bumpy Ride Ahead

    European banks' CoCos are in crisis. What investors who hold these high-reward but high-risk bonds should know.
  3. Your Practice

    What the Next Decade Holds for Financial Advisors

    A look at the top trends of the financial advisory business in the next decade.
  4. Mutual Funds & ETFs

    The 3 Best T. Rowe Price Funds for Value Investors in 2016

    Read analyses of the top three T. Rowe Price value funds open to new investors, and learn about their investment objectives and historical performances.
  5. Active Trading Fundamentals

    4 Stocks With Bullish Head and Shoulders Patterns for 2016 (PG, ETR)

    Discover analyses of the top four stocks with bullish head and shoulders patterns forming in 2016, and learn the prices at which they should be considered.
  6. Stock Analysis

    Performance Review: Emerging Markets Equities in 2015

    Find out why emerging markets struggled in 2015 and why a half-decade long trend of poor returns is proving optimistic growth investors wrong.
  7. Investing

    Don't Freak Out Over Black Swans; Be Prepared

    Could 2016 be a big year for black swans? Who knows? Here's what black swans are, how they can devastate the unprepared, and how the prepared can emerge unscathed.
  8. Investing News

    Today's Sell-off: Are We in a Margin Liquidation?

    If we're in market liquidation, is it good news or bad news? That party depends on your timeframe.
  9. Chart Advisor

    Uptrending Stocks Dwindle, a Few Remain (EW, WEC, WR)

    The number of uptrending stocks is shrinking, but here a few that remain in uptrends.
  10. Chart Advisor

    Trade Setups Based on Descending Trend Channels (LBTYK, RRC)

    These descending trend channels have provided reliable sell signals in the past, and are giving the signal again.
RELATED TERMS
  1. Collateralized Mortgage Obligation ...

    A type of mortgage-backed security in which principal repayments ...
  2. IRR Rule

    A measure for evaluating whether to proceed with a project or ...
  3. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and ...
  4. Golden Cross

    A crossover involving a security's short-term moving average ...
  5. Cup and Handle

    A pattern on bar charts resembling a cup with a handle. The cup ...
  6. Percentage Change

    Percentage change is a simple mathematical concept that represents ...
RELATED FAQS
  1. When does a growth stock turn into a value opportunity?

    A growth stock turns into a value opportunity when it trades at a reasonable multiple of the company's earnings per share ... Read Full Answer >>
  2. What is Fibonacci retracement, and where do the ratios that are used come from?

    Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician ... Read Full Answer >>
  3. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  4. What is securitization?

    Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming ... Read Full Answer >>
  5. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  6. How do I calculate the P/E ratio of a company?

    The price-earnings ratio (P/E ratio) is a valuation measure that compares the level of stock prices to the level of corporate ... Read Full Answer >>
Hot Definitions
  1. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  2. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  3. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  4. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  5. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
Trading Center