How to use 2% trading rule in money management
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The 2% rule is used as part of money management by successful traders everywhere. This well known rule states that even if market conditions are 100% perfect, you must not risk too much on a single trade. Going in with ‘all you got’ happens in a betting environment like a poker game where players go ‘all in’ if they have a top hand. This rule does not apply to Forex trading. The reason why is there is always some factor outside of our control that can reverse the market into the opposite direction and take our stop loss out. So, the point of the 2% rule is that even though market conditions are perfect, always ensure that you know what the worst case scenario is.
Explanation of the rule
The 2% rule applies to the risk part of your trade i.e. the amount of pips you are using for your stop loss. For example, if you are using a 10 pip stop loss you must ensure that the money you assign to those 10 pips is no more than 2% of your total investment per day. This way you are setting yourself a 2% stop loss limit per day. If your stop loss is hit, then you have reached your daily limit and that is when you stop trading.
Let’s analyse this in a further example. Let’s pretend that you have $1000 in your trading account. 2% of $1000 is $50. So this $50 is the maximum you are allowing yourself to lose per day. Now, if you are using a 10 pip stop loss, the maximum you should invest in that trade is $5 per pip. The reason for that is because $5 x 10 pips = $50 which is your maximum daily loss limit and equates to your 2% of total investment. Our video tutorial provides a great example so this will be the best time to watch it.
Again, if your stop loss is hit, you cannot take another order for the rest of the day but if you win you now have a higher amount to risk because your total investment has increased i.e. we now have our winnings plus the original $1000 we started with so we simply calculate a new 2% figure.
Spreading the risk
To spread out the risk you can apply the rule to two or three trades rather than just one. This way you are guaranteed to have three attempts at generating the profit but the amount of investment will be lower in each trade individually because the 2% risk has to be divided into three separate portions. After you have results from all three trades you can apply the rule to the new total investment you have.
Please also remember to include all other charges such as the spread or the overnight swap rate if you are using higher time frames to ensure that your calculation is as specific as possible.