The 1% Money Management Rule
Trading financial markets always carries market risk and this can be due to known or unknown events such as political events, central bank intervention just to name a few. Not all risks can be totally eliminated and it is very important to always keep this in mind.
As a trader you will always be dealing with risk. Risk here means a potential for a loss! If you want to be a successful trader you must be aware of the risk you are taking and you must be able to manage your risk. Profits will follow only if you can manage your downside, the risk, first.
To put it simple, if you are not aware of the risks you are taking and not managing your risk, taking too much risk and, then you are in fact not trading but gambling!
Just remember that, successful trader are excellent risk managers to begin with. If you lose a big chunk of your money or your trading account all together then you have no more money left over to trade the next day.
There are some simple but powerful risk management rules which many don’t know and many who know simply overlook them and so do not apply them in their trading as strange as it may sound! Applying what you know will require you to be disciplined and that is the part of a psychology of a successful trader which you will develop along your journey of becoming a profitable trader.
Let’s now talk about the 1% rule and how it can protect your trading account against serious damages to your account and also significantly improve your trading performance over the long run.
The 1% rule:
By adhering to this rule you will never risk more than 1% of your total current balance in your trading account on any one trade. Some traders suggest a 2% instead but if you are a beginner trader it is sensible to stick to the 1% rule and minimizing your risk while still learning. Many professional traders who manage big funds even risk less than 1% of their account on each trade.
First let’s see how the 1% rule actually works before then elaborating about the benefits of using it.
Example 1: Lets say your trading account is $5,000 and you wish to open a trade applying the 1% rule. This means that the maximum you’d be okay to risk on your account by opening a trade is going to be $50. Here is how you simply calculate this: $5,000 x 1% = $50.
Example 2: If your have a trading account of $10,000 then the maximum position you can open at any one time is again 1% which for this example that would be $100 and here is how simply we calculated this $10,000 x 1% = $100.
Example 3: You have $15,000 available in your trading account. You want to short EUR/USD. Based on your entry your entry is 1.1360 and want to exit at 1.1330. The distance between your entry stop loss in this example is 30 pips; 1.1360 – 1.1330 = 30 pips. You want to risk 1% of your account on this trade which is $150; $15,000 x 1% = $150. Your position size therefore would be $5 per each pip.
By sticking to the 1% rule you will make sure that no one trade can ever harm your account or put you out of the business of trading. Remember, no more money in your trading account resulting no more trading if you have no other money left! In the above example if you had a $50 loss on your trade that should not weaken your confidence or unsettle you in anyway hence you accepted a potential loss of $50 beforehand and that you already counted for that in your strategy. We will talk about the importance of confidence in another article.
Also, by adhering to the 1% rule you will make sure you’re comfortably following your plan and are able to take many small trades without the constant fear of a few losses in a row which, may happen from time to time. If you happen to get a couple of losses in a row you still can confidently follow your trading plan and stick to your winning strategy as long as you stick to the 1% rule.
Lets say that you had 5 small losses , 1% on each trade, in a row and you’re trading a $1,000 account. After the first loss your account will drop to $990 and after the 5th loss you’re still left with $950.99 in your account! Despite 5 losses in a row in this scenario, you still have plenty of money to trade if you want to and you still have a chance to learn from your mistakes. This would not be the case if you risked 5% or 10% on each trade in which case your account could suffer a serious damage after 5 losses in a row in this example!
After all, you may be using a new strategy and not sure why you got 5 losses in a row, if you need to, you can pause your trading and investigate your trade and make sure your strategy is fit for the market condition and etc. On the other hand, if you’re confident about your strategy you still can continue to trade. By adhering to the 1% Rule you have options meeting your particular needs and situation without losing your nerve and this is wonderful. Isn’t it? You’ still have sufficient time and money in your account to trade if you want to and closely monitor and understand better how your your strategy is performing despite encountering a row of small losing trades. You live for another day to learn from your mistakes if any and continue to trade for days to come like a professional trader.
Back to the psychology of successful trading here mentioned earlier above. Many who already know the simple 1% money management rule unfortunately still overlook it and trade emotionally just hoping to be lucky this time or that time by way of risking a lot to profit big. Remember, if you trade big you can lose big too. Trading does not work like that and if you truly want to stay in the game long enough and to be a profitable trader then you’ll need to be disciplined and have a long term perspective about your business. Manage your risk first and profitability will follow and hopefully you’ll be delighted over and over again during your journey of profitable trading.
Safe trading is happy trading.