The 2 percent rule

One of the principles of risk management is the 2 percent rule. The rule states that no more than 2 percent of a total portfolio should be lost on any individual trade. Ideally this figure should include the costs of commissions and slippage. This means that the largest loss you should tolerate on any single trade is 2 percent of your portfolio. Some people misinterpret this rule to mean that only 2 percent

*Schwager, Jack, Technical Analysis of Stocks and Commodities. Technical Analysis, Inc., June 1999, p. 26.

of your trading equity should be allocated to each trade, but that's not the case. The 2 percent rule is designed to limit a trader's losses while preserving capital. It is powerful insurance because it provides a trader with a number; you know before you enter a trade how much you can afford to lose. Applying this principle, a trader can afford to be wrong numerous times and still live to see the next trading day.

Keeping your losses to 2 percent per trade often means that you will have to trade smaller positions. Many traders who are just starting scoff at the idea, thinking that bigger positions will allow them to strike it big and make a large monthly income through big profits. Nothing could be further from the truth. When beginning traders take on bigger positions, it often causes them to lose money faster because they have not built up the tolerance for accepting larger losses or bigger profits. They tend to take profits off the table faster when they are winning, because of the immediate gratification associated with being right. They also tend to let their losers run longer, because they are not willing to accept the pain associated with being wrong.

It is not uncommon for traders to enter into positions not knowing beforehand how much they are willing to lose, because they think they are going to win. When expectations for a trade are not met and no exit strategy exists, a trader is often forced to cut a position based on either emotion or financial pain. The goal of a trader should be to accept losses without letting them affect his confidence. This is accomplished through preparation before the trade, budgeting for losses just as you budget for an insurance bill.

The 2 percent rule is pivotal because the success of an individual is not necessarily correlated to the number of winning trades: Some of the most successful traders on Wall Street earn up to 80 percent of their profits from just 20 percent of their trades. This means that the majority of their trades may not earn them the big money. The reason they are profitable as a trader is that they have learned to quickly accept and manage loss, not disregard or try to eliminate it. Successful traders aim to keep loss controlled. When losses are controlled a trader is free to focus on and add to winning trades.

By limiting individual losses to 2 percent or less of your portfolio, you increase the odds that you will experience more break-even and winning trades. Over time, these trades tip the scales toward profitability, as long as losses are managed. The 2 percent rule is par ticularly beneficial for beginning traders. Your probabilities of success increase with the number of times you play. A 2 percent maximum loss guideline increases the life span of beginning traders, providing them with the opportunity to learn from their mistakes.

A loss of 6 percent to 8 percent is the maximum a trader should accept for the entire month. A trader who has four consecutive 2 percent losses should stop trading for the month and evaluate what's going wrong. You can always begin anew the following month. Taking time off after a string of losses is beneficial, because it provides you with an opportunity to regain your confidence. A trading time-out is similar to a basketball time-out after the opposing team has scored a number of unanswered points. The time-out slows the winning team's momentum and helps the losing team regain confidence with a pep talk and a breather. If you enter a trading day lacking confidence, close the shop and begin again tomorrow. Confidence in yourself and what you are doing is your strongest ally.

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