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.
Success Rate (Reliability)
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 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
If we have three traders:
| 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 |
Trader A
Trades short-term and averages 125% profit over all his trades.
| Winning trades: | 75% * 1 | 0.75 |
| Less: Losing Trades | 25% * 1 | -0.25 |
| Average Profit | .50 | |
| As a percentage of capital at risk | 50% |
Trader B
Trades medium-term and averages 200% profit over all his trades.
| 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% |
Trader C
Trades long-term and averages 325% profit over all her trades.
| 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://vassarstats.net/textbook/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).
