Day Traders, Stick To The 1% Risk Rule
Career day traders stick to a method called the 1% risk rule (or a slight variation of it). It assures minimal capital is lost when they aren't trading well or market conditions are tough, yet still allows for great monthly returns/income. Here's what the 1% risk rule is, and why you should follow it.
1% Risk Rule
The 1% percent risk rule is never risking more than 1% of your account on a single trade.
That doesn't mean if you have a $30,000 trading account you can only buy $300 worth of stock (1% of $30,000). In fact, you can use all your capital on a single trade, or even more if you utilize leverage. Implementing the 1% risk rule means you take risk management steps so that you (likely) don't lose more than 1%--$300 in this case--on a single trade. How to apply these risk management techniques, so you only risk 1% of your account on each trade, is discussed below.
Reasons For Using the 1% Risk Rule
Trading is tough, and no one wins every trade. The 1% risk rule helps protect a trader's capital from declining significantly when they aren't trading well or when market conditions are making it tough to make money. If you risk 1% of your current account balance on each trade you would need to lose 100 trades in a row to wipe out the account. If novice traders followed the 1% rule, many more of them would likely last through the very difficult first year.
Risking 1% (or less) per trade may seem like a small amount to some people, and yet it can still provide great returns. If you are risking 1%, your profit expectation on each trade should be 1.5% to 2%, or more. Making several trades a day, gaining a few percentage points on your account each day is quite possible, even if you only win half of your trades.
Here's how to do it.
1% Risk Rule Application
By risking 1% of our own account, on a single trade, we are trading on our own terms. By that I mean you can make a trade which that gives you a 2% return on your account, even though the market only moved a fraction of a percent. Similarly, you can risk 1% of your account even if the price typically moves 5% or 0.5%. This is done using targets and stop loss orders.
Once you learn how to day trade stocks--or other market such as futures or forex--assume you see a trade setup where you want to buy a stock at $15. You have a $30,000 account. You look at the chart and see the price recently put in a short-term swing low at $14.90. You place a stop loss at $14.89, one cent below the recent low (see Where to Place a Stop Loss). Now that you know your stop loss location you can calculate how many shares to take so you don't lose more than 1% of your account.
1% of $30,000 is $300, that is your account risk. Your trade risk is $0.11, which is the difference between your entry price and stop loss price. Divide your account risk by your trade risk to get the proper position size: $300 / $0.11 = 2727 shares. Round this down to 2700. That is how many shares you can take, for this trade, so you don't lose more than 1% of your account.
Note that 2700 shares at $15 costs $40,500, which is more than the trader has. Therefore, leverage of at least 2:1 is required to make this trade.
If the price hits your stop loss you will lose about 1% of your capital, or close to $300 in this case. But if the price moves higher and you exit at the $15.22 you make almost 2% on your money, or close to $600 (less commissions). This is because your position is calibrated to make or lose almost 1% for each $0.11 the price moves. If you exit at $15.33 you make almost 3% on the trade, even though the price only moved about 2%.
Type of method allows trades to adapt to adapt to all type of markets conditions, whether volatile or sedate and still make money. The method is also applicable to all markets. Before trading be aware of slippage; that is when you're unable to get out at the stop loss price and could take a bigger loss than expected.
Variations of the Rule
The 1% risk rule is common for people with trading accounts of less than $100,000. While 1% is recommended, once you're consistently profitable some traders use a 2% risk rule. It's the same, except you're allowed to risk 2%. A middle ground would be only risking 1.5%, or any other percentage below 2%.
For accounts over $100,000 many traders risk less than 1%. For example, they may only risk 0.5%, or even 0.1% a on large account. When short-term trading it becomes hard to even risk 1% because the position sizes get so big. Each trader finds a percentage they feel comfortable with and that suits the liquidity of the market they are trading. Whichever percentage you choose, keep it below 2%.
Final Word on the 1% Risk Rule
The 1% rule can be tweaked to suit each individual trader's account size and market. Set a percentage you are OK with risking and then calculate your position size for each trade according to the entry price and stop loss. Following the 1% rule means you can withstand a long string of losses. Assuming winners are bigger than losers you'll find your capital doesn't drop very quickly but can rise rather quickly. Before risking any money, even 1%, it's recommended you practice a strategy in a demo account and make sure you are consistently profitable with it.