- 2, 6 rule
- Iron triangle of risk control (How many shares to trade?)
- The concept of risk control (Where to stop?)
In the markets it hardly matters how good your trading system is..
What matters is if you can count or not.
Confused? Even i was for many years before understanding the importance of Risk management in trading. There is one missing element in your trading and realizing it alone does not help, trusting and welcoming it does. Here is a small article inspired from one of the best books on Psychology and risk management. I will leave the link to this book at the end of the article.
A good trading system will give you an edge in the long run, but in the short run
there is a great deal of randomness in the markets. The outcome of any single trade
is close to a toss-up. A professional trader expects to be profitable by the end of the month or the quarter, but ask him whether he’ll make money on his next trade and
he’ll honestly say he doesn’t know. That’s why he uses such risk management rules: to prevent negative trades from damaging his account.
THE TWO PERCENT RULE
One disastrous loss can do to an account what a shark does to a hapless swimmer. A
poor beginner who loses a quarter of his equity in a single trade is like a swimmer
who just lost an arm or a leg to a shark and is bleeding into the water. He’d have to generate a 33% return on the remaining capital simply to come back to even. The
chances of him being able to do that are slim to none.
The typical victim of a “shark bite” loses more money. He loses confidence and
becomes fearful of pulling the trigger. The way to avoid “shark bite” losses is by following:
The 2% Rule prohibits you from risking more than 2% of your account
equity on any single trade.
For example, if you have 50,000 in your account, the 2% Rule limits your maximum
risk on any trade to 1,000.
Let’s say you decide to buy a stock for $40 and put a stop at $38, just below support. This means you’ll be risking $2 per share. Dividing your total permitted risk of $1,000 by your $2 risk per share tells you that you may trade no more than 500 shares.
THE IRON TRIANGLE OF RISK CONTROL
How many shares will you buy or sell short in your next trade? Beginners often
choose an arbitrary number, such as a thousand or 200 shares. They may buy more if
they’ve made money in their latest trade or less if they’ve lost money.
In fact, trade size should be based on a formula instead of vague gut feel. Use the
2% Rule to make rational decisions on the maximum number of shares you may buy
or sell short in any trade.
Construct the Iron Triangle in three steps:
A. Your maximum dollar risk for the trade you’re planning (never more than 2% of your account).
B. The distance, in dollars, from your planned entry to your stop—your maximum risk per share.
C. Divide “A” by “B” to find the maximum number of shares you may trade. You aren’t
obligated to trade this many shares, but you may not trade more than this number
The Six Percent Rule
A piranha is a tropical river fish not much bigger than a man’s hand, but with a mean set of teeth. What makes it so dangerous is that it attacks in packs. If a dog, a donkey, or a person stumbles into a tropical stream, a pack of piranhas can attack with such a mass of bites that the victim collapses. A bull can walk into a river, be attacked by a pack of piranhas, and a few minutes later only its bones will be left in the water.
A trader, who keeps sharks at bay with the 2% Rule, still needs protection from piranhas.
The 6% Rule will save you from being nibbled to death.
Most of us, when we find ourselves in trouble, start pushing harder. Losing traders
often take on bigger positions, trying to trade their way out of a hole. A better
response to a losing streak is to step aside and take time off to think. The 6% Rule
sets a limit on the maximum monthly draw-down in any account. If you reach it, you
stop trading for the rest of the month. The 6% Rule forces you to get out of the water before piranhas get you.
The 6% Rule prohibits you from opening any new trades for the rest of
the month when the sum of your losses for the current month and the
risks in open trades reach 6% of your account equity.
THE CONCEPT OF AVAILABLE RISK
Before you put on a trade, ask yourself: what would happen if all your trades suddenly turned against you? If you used the 2% Rule to set stops and trade sizes, the 6% Rule will limit the maximum total loss that your account may suffer.
1. Add up all your losses taken this month.
2. Add up your risks on all currently open trades. The dollar risk of any open position
is the distance from your entry to the current stop, multiplied by the trade
size. Suppose you’ve bought 200 shares for $50, with a stop at $48.50, risking
$1.50 per share. In that case, your open risk is $300. If that trade starts going
your way and you move your stop to breakeven, your open risk will become zero.
3. Add the two lines above (losses for the month plus risks on open trades). If
their sum comes to 6% of what your account equity was at the beginning of the
month, you may not put on another trade until the end of the month or until the
open trades move in your favor, allowing you to raise your stops.
Let’s review an example, assuming, for the sake of simplicity, that a trader will
risk 2% of his account equity on any given trade-
1. At the end of the month, a trader has $50,000 in his account, with no open positions. He writes down his maximum risk levels for the month ahead—2% or
$1,000 per trade and 6% or $3,000 for the account as a whole.
2. Several days later he sees a very attractive stock A, figures out where to put his stop, and buys a position that puts $1,000, or 2% of his equity, at risk.
3. A few days later he sees a stock B, and puts on a similar trade, risking another
4. By the end of the week he sees a stock C, and buys it, risking another $1,000.
5. The next week he sees a stock D, more attractive than any of the three above. May he buy it? No, he may not, because his account is already exposed to 6% risk. He has three open trades, risking 2% on each, which means he may lose 6% if the market turns against him. The 6% Rule prohibits him from taking any more risks at this time.
6. A few days later, the stock A rallies and the trader moves his stop above breakeven.
Stock D, which he wasn’t allowed to trade just a few days ago, still looks very attractive. May he buy it now? Yes, he may, because his current risk is only 4% of his account. He is risking 2% in stock B and another 2% in stock C, but nothing in stock A, because its stop is above breakeven. The trader buys stock D, risking another $1,000 or 2%.
7. Later in the week, the trader sees stock E, which looks very bullish. May he buy
it? Not according to the 6% Rule because his account is already exposed to a
combined risk of 6% in stocks B, C, and D (there is no longer a risk in stock A).
He may not buy stock E.
8. A few days later, stock B hits its stop. Stock E still looks attractive. May he buy it?
No, since he already lost 2% on stock B and has a 4% exposure to risk in stocks
C and D. Adding another position at this time would expose him to more than
6% risk per month.
Many traders go through emotional swings, feeling elated at the highs and gloomy
at the lows. Those mood swings will not help you trade, just the opposite. It is better
to invest your energy in risk control. The 2% and the 6% Rules will convert your
good intentions into the reality of safer trading.
You may order the book ‘The New Trading for a Living: Psychology, Discipline, Trading Tools and Systems, Risk Control, Trade Management (Wiley Trading) By Dr. Alxander Elder’ from here: