Day traders around the world stick to the one percent risk rule or may even vary it to a little extent to match their trading style. In fact, adhering to this rule allows them to minimize their capital losses, especially when they experience off-days while trading or when the market conditions are not in accordance with their expectations. By simply sticking to the 1% rule, traders can maximize their monthly income or returns through trading. Continue reading to find out why day traders must stick to the 1% risk rule when it comes to trading.
Why 1% Risk Rule Makes Sense?
The 1% risk rule is simple and straightforward. As traders you are not required to risk any amount that is in excess of 1% of the amount in your trading account for one single trade. However, this does not imply that if your account’s balance is $40,000, then you are allowed to purchase only $400 of stock, which in essence is 1% of $40,000. As a trader you could use your entire capital amount or much more than that if you choose to use leverage. Thus, implementing 1% risk rule implies that you undertake effective risk management steps for restricting your losses to just one percent and nothing in excess of that for a single trade. It is important to understand that as a trader, you can never win all your trades and the one percent rule assists you in ensuring that your capital does not decline any further, particularly when the conditions are not favorable.
Traders who are new to the world of trading can stick to the 1% risk rule to get through their initial months of trading. While, many traders may feel that risking 1% or even less for every single trade is a much smaller amount, the fact is that it can provide them with great returns. In case you choose to risk 1%, you must set the profit expectation or goal in the range 1-2% for every individual trade. Hence, when traders enter into a number of trades throughout the day, they can easily gain a couple of percentage points on their account every day, despite them winning only half of their trades.
How to Apply the 1% Risk Rule?
By risking one percent of their trading account on one trade, traders can easily enter into a trade that provides them with a 1-2% return on their account, even when the market may have moved slightly or by a fraction. In the same way, you could risk 1% of the trading account even when the price goes up by 5% or 0.5%. This can be done by utilizing targets as well as stop-loss orders. Thus, traders can apply the risk rule to day trading stocks or to forex and futures. For instance, if you wish to purchase a stock at $16 and have $31,000 in your account and when you check the chart, you find that the price was at a $15.90. Now, you can place your stop-loss order at $15.89, and calculate the number of shares that you wish to purchase while risking nothing over 1% of the amount in your trading account. Hence, the risk that you can take as per your account balance is 1% of $31,000 or $310. Your trading risk on the other hand is equal to $0.11, which is calculated in the form of the difference between the stock buying price as well as stop loss order price.
Now if you divide the account risk amount by the trade risk amount to get your position size then it would be $310/$0.11=2818 shares. Now, you can round this to 2800 and this clarifies the number of shares that you can purchase in a trade, without risking anything over 1%. It must also be noted that 2800 shares at $16 cost $44,800, which is more than the $31000 in your account. Hence, you would require a leverage of a minimum of 2:1 to be able to make such a trade.
This method helps you to trade irrespective of whether the market is sedate or volatile and still earn money. In fact, you can easily use this risk rule for trading in all types of markets. Also, before you trade, you must take slippage into account, wherein one is unable to exit at the stop loss price and thus takes a much bigger loss in comparison to what they had expected.
Variation of the Percentage
Traders who have an amount lesser than $100,000 in their accounts usually rely on the 1% risk rule. While, the 1% risk rule is safer, some traders tend to use a 2% rule, when they register consistent profit. Thus, any percentage that is lower than 2% is useful for traders. Also, traders with more than $100,000 in their account may risk anything between 0.5 % or lower at 0.1% since their position size tends to get bigger. Typically, traders must choose a percentage that they are comfortable with and which is also in accordance with the market liquidity in which they choose to trade.
Traders can easily fix a percentage that they think they are comfortable with and later calculate the position size accordingly for every single trade. While, doing this, traders must also take the stop loss and entry price into account. This will help them to withstand a number of losses in a row and ensure that their capital does not drop too quickly.