Is the 2 Percent Rule Suitable for All Traders?
The 2 Percent Rule says:
NEVER RISK MORE THAN 2 PERCENT OF YOUR CAPITAL ON ANY ONE STOCK.
But not all traders face the same success rate (or reliability as Van Tharp calls it). Short-term traders usually achieve higher success rates, while long-term traders achieve for higher risk-reward ratios.
Your success rate is the number of winning trades expressed as a percentage of your total number of trades:
Success rate = winning trades / (winning trades + losing trades) * 100%
Risk-Reward Ratio is your expected gain compared to your capital at risk (it should really be called the reward/risk ratio because that is the way it is normally expressed). If your average gain (after deducting brokerage) on winning trades is $1000 and you have consistently risked $400 per trade (as in the earlier 2 percent rule example), then your risk-reward ratio would be 2.5 to 1 (i.e. $1000 / $400).
Risk-Reward ratio = average gain on winning trades / average capital at risk
If we have three traders:
Trades short-term and averages 125% profit over all his trades.
|Winning trades:||75% * 1||0.75|
|Less: Losing Trades||25% * 1||-0.25|
|As a percentage of capital at risk||50%|
Trades medium-term and averages 200% profit over all his trades.
|Winning trades:||50% * 3||1.50|
|Less: Losing Trades||50% * 1||-0.50|
|As a percentage of capital at risk||100%|
Trades long-term and averages 325% profit over all her trades.
|Winning trades:||25% * 10||2.50|
|Less: Losing Trades||75% * 1||-0.75|
|As a percentage of capital at risk||175%|
This does not necessarily mean that Trader C is more profitable than A. Trader A (short-term) is likely to make many more trades than Trader C. You could have the following situation:
|Number of Trades/Year||300||100||40|
|Times Return on Capital at Risk||150||100||70|
|Capital at Risk||2%||2%||2%|
|Annual % Return on Capital||300%||200%||140%|
We now calculate the relative risk that each trader has of a 20% draw-down. Use the binomial probability calculator at http://faculty.vassar.edu/lowry/ch5apx.html:
|Probability of 10 straight losses||0.0001%||0.1%||5.6%|
Obviously, the higher your success rate, the greater the percentage that you can risk on each trade.
Bear in mind that, with a higher risk-reward ratio, Trader C only needs one win in 10 trades to break even; while Trader A would need five wins. However, if we compare breakeven points, it is still clear that lower success rates are more likely to suffer from draw-downs.
|Number of wins (out of 10 trades) required to break even||5||2.5||1|
|Normal Success Rate||75%||50%||25%|
|Probability of making a net loss in 10 trades||2.0%||5.5%||5.6%|
Although your trading system may be profitable, if it is susceptible to large draw-downs, consider using a lower percentage of capital at risk (e.g. 1 percent).