When thinking about successful trading, what comes to your mind? Most traders would say it is finding a perfect trading opportunity and capitalizing on it. When in fact the correct answer is consistency. In order to trade successfully on a daily basis, the trader has to abide by certain rules. Risk management is clearly one of them, probably even the most important one, as those who wants to receive profit should first consider potential losses.
Risk management is a key concept that all rookie traders should wrap their heads around. Unfortunately, this topic is often being overlooked, sometimes even dismissed as unimportant. More than one trader has gone bankrupt due to lack of discipline and insufficient risk management.
When hoping for a single trade that would change your life for the better you are demonstrating the behavioral pattern of a gambler (which is obviously counterproductive). In reality, trading has nothing to do with gambling. The sooner you understand this the better. If you find yourself thinking about trading in terms of blind luck you are definitely doing something wrong. Risk management rules are here to bail you out and make your entire trading journey more productive.
The 2% rule
Once again, not being able to calculate the right amount of money to invest in every deal you make is very close to gambling. Allocating a thoroughly calculated amount of money, on the other hand, can pay off in the long-term. It is widely accepted that the optimal amount of money you invest in a single deal should not exceed 2% of your entire capital.
Don’t be afraid to calculate the exact amount of funds to be allocated to a single deal
Knowing how to control losses is as important for a successful trader as it is to spot a trend reversal, open the deal in the right direction etc.
No matter what trading strategy you use, you will occasionally come across a losing streak. This is when risk management rules are especially important. When winning one trade after another, it doesn’t matter whether you have 1% or 50% of your trading capital invested. Actually, you would be better off by allocating as much as possible when success is guaranteed. However, in reality, there is always a chance of failure (which is actually quite high).
You, therefore, want to find the balance between the potential profit and the loss you are quite likely to incur. 2% is big enough to guarantee you consistent results in the long run, at the same time giving you enough flexibility to survive a losing streak that will sooner or later occur. Let’s take a look at a losing streak of only 5 deals and compare what happens when allocating 2% and 10% of the trading capital to a single deal.
| # of the deal | 2% | 10% | |
| 0 | 10,000 | 10,000 | |
| 1 | 9,800 | 9,000 | |
| 2 | 9,604 | 8,100 | |
| 3 | 9,411 | 7,290 | |
| 4 | 9,223 | 6,561 | |
| 5 | 9,039 | 5,904 |
As you can see, there is a huge difference between 2% and 10%. When allocating 2% of your capital to a single deal you will lose only 10% of your initial capital. With 10% at stake, you will lose over 40% after a series of only 5 unsuccessful deals. Quite a difference! No matter how good you are at your best, at your worst you want to remain as humble and disciplined as possible.
Remember that as a trader, you are not looking for a jackpot. Instead, you should be interested is a series of small wins, each of them making you a little bit wealthier.
Fund allocation is not the only risk management rule to follow. Still, it is something to familiarize yourself with and, most importantly, use in your daily trading routine. Just following this simple rule can dramatically increase your chances of success.