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Trading > Money Management > Is 2% Right for Me?

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.

Risk-Reward Ratios

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

Confidence Levels

 Trader: A B C Time frame: Short-term Medium Long-term Success Rate: 75% 50% 25% Risk-Reward Ratio: 1.0 3.0 10.0

 Winning trades: 75% * 1 0.75 Less: Losing Trades 25% * 1 -0.25 Average Profit .50 As a percentage of capital at risk 50%

 Winning trades: 50% * 3 1.50 Less: Losing Trades 50% * 1 -0.50 Average Profit 1.00 As a percentage of capital at risk 100%

 Winning trades: 25% * 10 2.50 Less: Losing Trades 75% * 1 -0.75 Average Profit 1.75 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:

 Trader: A B C Time frame: Short-term Medium Long-term Average Profit/Trade 50% 100% 175% 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%

Relative Risk

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:

 Trader A B C Success Rate 75% 50% 25% 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.

 Trader A B C 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%

Low Success Rates

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).