Trading capital: how much to risk on any one trade

Small losses are usually expressed as a percentage of your trading float. Studies suggest you should never risk more than two percent of your trading capital on any trade, and most professionals will tell you even that is too much: they risk one percent, down to as little as a quarter of a percent, per trade. The idea is that no single trade can meaningfully hurt your float either way.

I don't think many people appreciate how powerful this one rule is. By simply changing the amount you risk, you can turn a system returning 10 percent per annum into one returning 100 percent, from altering that one variable. Of course, increasing the risk increases the reward and the drawdown together, so while I recommend you never exceed two percent, I do recommend testing the variable so you understand its power for yourself.

The two percent rule in action

Take a trading float of 20,000 dollars. The two percent rule sets your maximum loss on any one trade at 400 dollars. The beauty of losses that small is the sheer string of them you'd need before your float was gone: 50 losses in a row before there was no trading capital left. With most trading systems the chance of 50 straight losses is very, very slim.

The chance of going broke is smaller still, because implemented correctly the two percent is calculated on the current float, not the starting one. Two percent of 20,000 dollars is 400 dollars; take one loss and the float is 19,600 dollars, so the next maximum loss is two percent of that, 392 dollars. Each loss shrinks the next maximum loss, and as the portfolio grows, you're happy to take on proportionally more risk as well.

Playing the figures forward: after a string of six losses in a row, the float has only decreased to 17,717 dollars. Six successive losses, and just 2,283 dollars lost. That's managing your risk.

The drawdown maths

Losses that small are also much easier to win back. In that example we lost a little over ten percent, and clawing back a ten percent loss takes an 11.1 percent gain to return the float to break even. Now imagine trading without money management and taking a 50 percent drawdown: you'd need a 100 percent return on the remaining capital just to break even. The bigger the drawdown, the harder it is to pull yourself out.

Trade to survive

Novices risk more than two percent of their trading capital. Now you know better. And if you're starting with a small float, that's no excuse for poor money management. Your goal should be trading to survive: if you can survive, the profits will come and the float will grow. Position yourself to endure long strings of losses so that when the market turns, you're still in it and positioned to capitalise. That is what setting a maximum loss is all about, and it's one piece of the broader trading money management picture. Where exactly the exit goes on each trade is the job of a stop, such as the Average True Range volatility stop.