How the 2% and 6% Rules Can Help With Risk Management

Risk control. It may not be the most glamorous aspect of a trading opportunity, but some traders say it’s among the most critical elements.

In a recent article, fund manager and Market Wizards author Jack Schwager said the most important investment advice he ever received was this:

“Know where you will get out before you get in.” 
—Bruce Kovner, the founder of [hedge fund] Caxton Associates LP

Many beginning traders tend to focus on indicators, pattern recognition, fundamental price/earnings data, and other trading methodologies, and push risk controls to the back burner.

Schwager says a planned exit strategy can help limit the damage to your account from any single trade. "Why is making the exit decision before you get in so important? Because before you get in is the only time you have complete objectivity. Once you are in a trade, emotions take over, and you no longer have the clarity you had before you had the position," says Schwager.

Not sure how to set your risk control strategy? Although there’s no one-size-fits-all exit strategy, some traders have considered an approach suggested by Dr. Alexander Elder in his 2014 book, The New Trading for a Living.

Create Some Rules for Yourself

If you’re looking for ideas on how to create a rules-based trade management approach, Elder recommends employing the 2% rule and the 6% rule to potentially limit your exposure on a single trade and to help you retreat from what might be a difficult trading environment.

2% rule: Don't risk more than 2% of your account equity on any one trade.

The goal of trading, in general, is to make money, right? But in order to make money, you need trading capital. Even if you’ve had a series of non-winning trades, the 2% rule is designed to keep you in the game—“around,” as they say, “to trade another day.”

The rule says to take stock of your account size at the beginning of each month. If your trading account totals $20,000, the 2% rule allows you to risk a total of $400 per trade. On the first day of every month, you can revise the amount of your "risk allowance" as your trading account changes size.

How do you calculate the 2%? It's not the size of your trade; it's the amount you place at risk. Measure the distance of your entry point to your planned exit points, such as limit orders or stop-loss orders. Keep in mind, though, that a stop-loss order doesn’t guarantee you’ll get your order filled at the trigger price. Once activated, a stop-loss becomes a market order, competing with other orders for execution.

6% rule: No new trades will be opened for the remainder of the month if the sum of your losses for the current month, and the risk in open trades, hits 6% of your total account equity.

A goal of any trader, especially one just starting out, is long-term survival. Some traders find they need that occasional break to clear their heads and allow them to regain focus. Some see a challenging period in the market as a signal to step back. Some may shift to simulated trading for the remainder of the month. Others may take a break from the markets completely.

Trading can be a fun and rewarding journey, but there are plenty of potential risks that might block the path from time to time. Knowing when to pull into a rest stop might help you reach your destination.