Who wants to lose their hard-earned money? No one, of course. Traders always try to minimize losses. A standard solution for this is to not risk more than 2% of funds in any single transaction. This is called the 2% rule.
What is the concept of the 2% rule?
The 2% rule is an investment strategy in which investors’ risk in any single transaction does not exceed 2% of their available capital. To implement the 2% rule, investors must first calculate 2% of their available trading capital: this is called risk capital (CaR). Traders should also include brokerage fees for buying and selling stocks in the calculation to determine the maximum allowable amount of risk capital. Then, you traders should divide the maximum permissible risk by the stop loss amount. It helps traders determine the number of shares that can be purchased.
Suppose you have 10,000 USD in capital. At some point, you may continue to lose money for an extended time and fail ten consecutive transactions. If you assume a 2% capital risk per transaction, your balance will eventually be $8,171. Retaking risks will lead to more significant losses. For example, if you prefer a 5% policy, you will only have $5,987 left.
How does the 2% rule work?
The 2% rule restricts investors on their trading activities to stay within the specified risk management parameters. For example, an investor who uses the 2% rule and has a USD 100,000 trading account risks no more than USD 2,000 or 2% of the account value on a particular investment. By knowing the percentage of investment capital that may bear the risk, investors can reversely determine the total number of stocks to buy. Investors can also use stop-loss orders to limit downside risk.
If market conditions change, investors can implement stop-loss orders to limit their downside risks, and the loss will only account for 2% of their total trading capital. Even if a trader loses ten times in a row, their account will only decrease by 20% using this investment strategy. The 2% rule can be combined with other risk management strategies to help protect traders’ capital. For example, if the maximum allowable amount of capital they are willing to assume is reached, investors may stop trading that month.
How to calculate and practice it
This is necessary every time your balance changes. Just multiply all available funds by 2%. If you have US$200,000 in the capital, US$4,000 is the maximum risk you should bear in any transaction.
After determining the appropriate entry and exit points for the transaction, you can measure its risk.
To calculate the risk, find the spread between the entry price and the stop loss. One point represents 1% of most currencies.
Forex traders tend to trade in batches. The standard for lot size is 100,000 currency units. It is also common to trade in mini, macro, or nano lots of 10,000, 1,000, and 100 units, respectively.
Suppose that after measuring your trading risk in points, you convert it to U.S. dollars and realize that you may lose $400 per lot. This is 1/10 of the $4,000 you calculated in step 1.
Therefore, if you use the 2% rule in this case, please do not trade more than ten lots at a time.
Sum up
We hope our article helps you minimize your future losses. Implementing the 2% rule can hedge losses and protect your capital. Make sure to follow these steps to apply the policy to foreign exchange transactions correctly.
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