Two Simple Rules That Keep You In The Trading Game
December 15, 2008 by Vagabond Investors · 2 Comments
Money management and position sizing are probably the most misunderstood concepts in trading. We have only two goals in every single trade we make.
1. Make money
2. Learn
We can’t do both every time but for sure we should get at least one of them.
In my early days of trading I wasn’t aware of the importance of solid money management. In my opinion, it pays big money to take it very seriously. Money management keeps us in the game. It makes sure that we don’t get lethally hurt in any trade. I’ll run you through one simple and easy-to-use money management system, which I have used for several years.
The Rule Of 2%
The rule of 2% simply says that you never risk more than 2% of your trading account capital in one trade. I always – and I do mean always – follow this rule. If 2% seems a lot, I don’t have to ever risk that much if I don’t want to. I might choose to risk 0.5%, 1%, 1.5% or 2%. I never ever risk more than 2%.
So what does this mean?
Let’s look at an overly simplified example. Let’s say we have $100,000 in our trading account. We have found a very attractive trading candidate. We decide to enter this trade. The stock trades near its support level at $15.38. We figure out that a suitable stop-loss level would be at $14.12. Following the rule of 2%, how many shares do we buy?
The maximum loss we are willing to take is $15.38-$14.12=$1.26. On the other hand, 2% of our trading account of $100,000 is $2,000. We divide $2,000 by $1.26 (per share) and get 1,587 shares. Always round the number down never up. Include your brokerage fees and possible slippage in the 2%. So we decide to buy 1,500 shares.
One more thing we want to do here. We check that the total amount we put in the trade doesn’t exceed 25% of our total account. That would be $25,000 in this case.
The rule of 2% applies to any single trade I make. That’s very important. There’s another vitally important rule I wish to stress here.
The Rule Of 6%
The rule of 6% applies to my total open risk. It says that I never want to have more open risk positions than 6% of my trading account capital at the time. In other words, before I enter a trade, I check that my open positions in this new planned position don’t exceed $6,000, which is 6% of my $100,000.
Whenever the value of my account dips 6% below its closing value at the end of last month, I stop trading for the rest of this month.
Putting It Together
Here’s the idea of these rules. The 2% rule will keep me out from disastrous losses while the 6% rule will keep me out of long losing strings. Will I miss some fabulous opportunities as I follow these rules? Sure. It’s still vitally more important to follow the rules. Why? It keeps me in the game in the long run. It pays to have rules that keep you in the money tree year after year.
Let’s look at an example. Let’s say I make 30 horrible trades in a row, each of which loses the maximum following the rules I outlined above. I will still easily manage to protect over 55% of my trading capital.
|
Account |
MAX Risk |
Account |
MAX Risk |
Account |
MAX Risk |
||
|
100 000 |
2 000 |
81 707 |
1 634 |
66 761 |
1 335 |
||
|
98 000 |
1 960 |
80 073 |
1 601 |
65 426 |
1 309 |
||
|
96 040 |
1 921 |
78 472 |
1 569 |
64 117 |
1 282 |
||
|
94 119 |
1 882 |
76 902 |
1 538 |
62 835 |
1 257 |
||
|
92 237 |
1 845 |
75 364 |
1 507 |
61 578 |
1 232 |
||
|
90 392 |
1 808 |
73 857 |
1 477 |
60 346 |
1 207 |
||
|
88 584 |
1 772 |
72 380 |
1 448 |
59 140 |
1 183 |
||
|
86 813 |
1 736 |
70 932 |
1 419 |
57 957 |
1 159 |
||
|
85 076 |
1 702 |
69 514 |
1 390 |
56 798 |
1 136 |
||
|
83 375 |
1 667 |
68 123 |
1 362 |
55 662 |
1 113 |
Following these rules protect your capital. It gives you time and possibilities to learn from your trades. It gives you time to develop your trading system and setups. Combine this with a good record keeping and you will become a successful trader.
Although investing is one of my greatest passions, there are more important things in life than money. Personally, I’m about to have some more fun with my wife and daughter here in Thailand. I wish you all Merry Christmas and a Happy New Year!
Matias
