DEFINITION of 2% Rule
The 2% rule is a money management strategy where an investor risks no more than 2% of available capital on a single trade. To implement the 2% rule, the investor first calculates 2% of their available trading capital; this is referred to as the capital at risk. Brokerage fees for buying and selling shares are factored into the capital at risk to calculate the maximum permissible risk. The maximum permissible risk is then divided by the stop-loss amount to determine the number of shares that can be purchased.
BREAKING DOWN 2% Rule
If market conditions change and result in the trader getting stopped out of the trade, the downside exposure is limited as the losing trade represents only 2% of the total amount of trading capital available. Even if a trader has 10 consecutive losses, they only draw their account down by 20%. The 2% rule can be used with other risk management strategies to preserve a trader’s capital. For instance, an investor may stop trading for the month if their account falls below a maximum drawdown percentage.
The 2% rule is a restriction created by investors to stay within the risk management parameters of a trading system. For example, an investor who uses the 2% rule and has a $100,000 trading account, risks no more than $2,000 - or 2% of the value of the account on a particular investment. By knowing what percentage of investment capital may be risked, the investor can work backward to determine the total number of shares to purchase. The investor can also use stop-loss orders to limit downside risk.
Using the 2% Rule with a Stop Loss Order
Suppose that a trader has a $50,000 trading account and wants to trade Apple Inc. The trader can risk $1,000 of capital using the 2% rule ($50,000 x 0.02%). If Apple is trading at $170 and the trader wants to use a $15 stop loss, he or she can buy 67 shares ($1,000 / $15). If there is a $25 round turn commission charge, the trader can buy 65 shares ($975 / $15). In practice, traders must consider slippage costs and gap risk which have the potential to result in losses that are significantly greater than 2%. For instance, if the trader held the Apple position overnight and it opened at $140 the following day after an earnings announcement, it results in a 4% loss ($1,000 / $30).
(For more, see: Do Stop or Limit Orders Protect You Against Gaps in a Stock’s Price?)