Career day traders use a risk-management method called the 1% risk rule, or vary it slightly to fit their trading methods. Adherence to the rule keeps capital losses to a minimum when a trader has an off day or experiences harsh market conditions, while still allowing for great monthly returns or income. The 1% risk rule makes sense for many reasons, and you can benefit from understanding and using it as part of your trading strategy.
- The 1% rule for day traders limits the risk on any given trade to no more than 1% of a trader's total account value.
- Traders can risk 1% of their account by trading either large positions with tight stop-losses or small positions with stop-losses placed far away from the entry price.
- The profit target on these trades should be at least 1.5% or 2%.
- This is just a rule of thumb, and some traders may risk slightly more, while traders with larger account values may risk less than 1%.
The 1% Risk Rule
Following the rule means you never risk more than 1% of your account value on a single trade. That doesn't mean that if you have a $30,000 trading account, you can only buy $300 worth of stock, which would be 1% of $30,000.
You can use all of 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 prevent losses of more than 1% on any single trade.
No one wins every trade, and the 1% risk rule helps protect a trader's capital from declining significantly in unfavorable situations. 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 your account. If novice traders followed the 1% rule, many more of them would make it successfully through their first trading year.
Risking 1% or less per trade may seem like a small amount to some people, but it can still provide great returns. If you risk 1%, you should also set your profit goal or expectation on each successful trade to 1.5% to 2% or more. When making several trades a day, gaining a few percentage points on your account each day is entirely possible, even if you only win half of your trades.
Applying the Rule
By risking 1% of your account on a single trade, you can make a trade which 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%. You can achieve this by using targets and stop-loss orders.
You can use the rule to day trade stocks or other markets such as futures or forex. Suppose you want to buy a stock at $15, and 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 order at $14.89, one cent below the recent low price. Once you have identified your stop-loss location, you can calculate how many shares to buy while risking no more than 1% of your account.
Your account risk equates to 1% of $30,000, or $300. Your trade risk equals $0.11, calculated as the difference between your stock buy price and stop loss price.
Divide your account risk by your trade risk to get the proper position size: $300 / $0.11 = 2,727 shares. Round this down to 2,700, and this shows how many shares you can buy in this trade without exposing yourself to losses of more than 1% of your account. Note that 2,700 shares at $15 cost $40,500, which exceeds the value of your $30,000 account balance. Therefore, you need leverage of at least 2:1 to make this trade.
If the stock 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 sell your shares at $15.22, you make almost 2% on your money, or close to $600 (fewer 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%.
This method allows you to adapt trades to all types of market conditions, whether volatile or sedate and still make money. The method also applies to all markets. Before trading, you should be aware of slippage where you're unable to get out at the stop loss price and could take a bigger loss than expected.
Traders with trading accounts of less than $100,000 commonly use the 1% rule. While 1% offers more safety, once you're consistently profitable, some traders use a 2% risk rule, risking 2% of their account value per trade. 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 risk as little as 0.5% or even 0.1% on a large account. While short-term trading, it becomes difficult to risk even 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 in which they trade. Whichever percentage you choose, keep it below 2%.
The 1% rule can be tweaked to suit each trader's account size and market. Set a percentage you feel comfortable 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 you have larger winning trades than losers, you'll find your capital doesn't drop very quickly but can rise rather quickly. Before risking any money—even 1%—practice your strategy in a demo account and work to make consistent profits before investing your actual capital.
Frequently Asked Questions (FAQs)
How do you use risk management when trading on Nadex?
Nadex binary options are specific yes/no contracts, so the bulk of your risk management should take place before buying an option. Once you're in the trade, you can close out the trade to cut your losses.
Why are some trading strategies riskier than others?
In general, the higher the risk on a trade, the higher the potential reward. Options that are out of the money (OTM) are less likely to expire at the strike price—they're riskier. However, if that strike price hits, then the OTM options trader will see a higher return percentage than the trader who bought a safer, in-the-money option. That's just one example to demonstrate the most common relationship between risk and reward.