The 2% rule

[Naz]

Here are some thoughts.

When I started Trading I did all the beginners things, when I worked with traders I had to step it up and look at traders ideas.

I was trading slow go nowhere stocks/indices trying to analyse things, getting this and that right, they were trading momentum and playing with the markets money. When I stepped things up it was tough but I just reduced my position size so it cut down my monetary risk.

Then I noticed how momentum gave enourmous moves, one move could cover the risk from 5,6,7,8,9,10 loosing trades. There were different levels of momentum, very fast and medium moves, when I felt in the mood I traded fast momentum , when I was lazy I traded medium momentum.

I reckoned that if I made 100 points a day It was a good enough to earn a living from it.
However if I traded an index that only moved an average of 110 points a day I would have to be pretty good at getting my 100 points, but if I traded a momentum stock that regularly moved 1000 points I had a much better chance and it wouldnt take much to make hundreds of points and not just 100.

Over the years I noticed that the spread betting companies increased the amount of US stocks they offered. Because all the big momentum movers seem to have a reasonable capitalisation many are now offered by the spread betting companies.

This is now an oppertunity that exists to UK spread bettors as well as US day traders. Momentum can reduce your risk to nothing very quickly because of the nature of it's movement. Go nowhere markets run traders stops over and over again by the nature of their movement.

I made 516 points in 15 mins last Monday trading fast momentum, I attach the comments from the US traders watching me do it. It made me a weeks money very quickly. Last night MA ran 1,100 points in a couple of hours that was medium momentum.

 

[Naz]

Moving on.

Traders came to me and said Alan, we know the momentum is there could you make it easier for us to trade. So I set out to see what I could do.

If you use a lot of things in standard T/A you'll create belief at the wrong time and the market will fake moves to give you that belief. Price is the key. If something is trading at XYZ price that's what it's doing. So I focused on price and I got rid of all the rubbish that causes traders to get analysis paralysis during moves, the things that create indecision and sudden bad emotional judgements.

For instance I recently was in a trade, up about $2 or 200 points and decided to view the $tick. It completely upset the way I was trading giving me completely the wrong belief. I switched it off and I was at ease again. If we looked at what that indictor does it seems like a good logical thing to view. In reality it will make you take quick profits. I believe to many of these kind of indictors upset the mind and create the analysis paralysis in traders.

So I focused on price and removed the worry by making things clean. It told you the risk, it told you the entry and it told you the exit. I doubled my profits when I started using it, because when I wanted to get out and it would tell me the move was still intact, so I rode the momentum further.

I designed it for day traders but some FX traders got hold of it and use it for FX. Indeed in the daily charts of EURUSD it has called every swing for the last eighteen months. I shared a speaking platform with EP and said jokingly forget the analysis just use my new charts and you'll clean up. He took one look at them and asked if he could have them, I politely refused.

This year I was flown over to New York and invited to a trading office around the corner from Wall st to show them off. After demonstrating them on the live markets, one trader said to me that guy has done 15 years with Goldman and you just shafted his trading models in one hour by following the price and not his fancy indicators. So I want them.

I cant show them here because of the no advertising rule, but look on the web for me and I'll sure you'll spot them. This is one way many of us get the big momentum moves and make hundreds of points at a time.

Alan

 

[PitBull]

Hi Alan

Nice to see you back. Quality Stuff!

Lee

 

[Naz]

Hi Lee

I cant be back all the time but might post when I can.

Good to see some old faces still here.

Alan

 

[nunrgguy]

For me abottoml is talking much sense. There isn't a 2% 'rule', the amount of risk you can accomodate is determined by win/loss ratio, risk/reward and number of trades taken - the probabilities of your trading style. If you assume the result of any trade to be random you can quite easily work out for a number of trades, the probable worst case and best case scenarios, also max drawdown you can expect. The only way you can do this, I suggest, is to manually backtest your trading methodology (I use a simulator on past data) to find your win/loss ratio and average R:R.

Assuming you've done no backtesting (flying blind) with a small account, say £4000 and assume your win/loss ratio is 50/50, R:R is 1 and you're risking 2% of your account balance, over 800 trades (say) you could expect the following:
At some point 10 winners in a row
At some point 10 losers in a row (if you get more than this you'd be advised to stop, something has gone wrong)

Your best case result will be approx £7700, max drawdown 23%

Worst case result approx £730, max drawdown 86%!

The above all assumes no slippage, reduce the R:R to take account of that and you can see that you've just been killed.

The worst case is always the one to watch - clearly this 50/50 1:1 2% risk system has a very high probability of eventually blowing you out - time to go back to the drawing board, what yo uneed to aim for is a system where the worst case is ALWAYS higher than your original capital. Of course there are no guarantees, there is always scope for something to go wrong.

 

[Jaydee]

I agree with nunrgguy above:

Money management may have some stong psycological influences on a trader. However, the main reason for it is to endure drawdowns through periods of negative variance. The percentage of account equity risked will be a function of win/loss ratio coupled with average winner and average loser amounts.

The only exception to this is when a trader is starting out - no beginner should risk more than 1% of their account, regardless of how they trade, until consistency is acheived IMHO.

 

[stocktrader77]

I prefer to size according to a fixed % of my a/c adjusted for underlying volatility. The 2% rule is invalid because you could have a tight stop, which would dictate putting a large % of your a/c in 1 trade, then a black swan event would wipe you out. try and never expose more than 25% of your a/c to one position.

 

[nine]

That doesn't invalidate the "risk no more than 2% rule" it just suggests a better measure of risk should be used than the distance to your stop.

I'd suggest taking what stocktrader says and modifying the 2% rule to take some sort of worst case volatility into account. What is the worst historical movement you might expect in the period your stop is exposed (day or end of day say) allowing perhaps for the possibility of a 911 type event closing the exchange just before your stop gets hit.

If that was the case I'd suggest that you don't want to expose more than 25% of your account to your portfolio's risk ... so if you have 5 long stock positions you need to add the hit on all of them for that black swan event.

 

[Hotch]

I think I misinterpreted the rule. (or the books I've read haven't explained it yet, too busy reading Feist).

I realise now (not sure if it's obvious to everyone else), that you can of course risk only 2% by using stops (so I haven't been risking lots of my account).

Been meaning to type that up for ages :X

 

[fibonelli]

Maybe we need to think of risk in a different way.