Today’s article is about debunking the 2% money management rule that is so popular among much of the trading community. A lot of people out there have disagreed with me on this topic in the past so I wanted to write about it today to clarify my views on it. I’m going to put forward some strong arguments against relying on the 2% rule that I hope will save you money and open your eyes. You really need to pay attention to what I’ve got to say today because it could improve your trading results significantly.
Debunking the 2% rule
The 2% money management (MM) rule likely started in stock trading and longer-term investing many years ago. It is based on the idea that you would be in multiple positions at any one time and that you’d only risk 2% of your net equity on any one of those positions. For example, you might have 100k in your account and 20 active stock trades at 2% risk each. The 2% rule really started as a way for investors to spread their risk capital amongst a diversified spectrum of stocks and investments, but it was never intended to be used the way that many Forex traders use it these days…
The idea that the active Forex swing trader should also risk 2% of his or her account on every trade is simply illogical. The 2% rule is essentially a myth that got perpetuated around the trading world because it seems to make sense and is easy to understand, but just because a bunch of people are talking about something, doesn’t mean it is correct or useful for every situation, in fact, often the opposite is true. There are some VERY big problems with the 2% rule if you are an active Forex swing trader who generally is only in one or two positions at a time, holding them for a few days or maybe a week on average…
Why the 2% rule is essentially rubbish…
First off, Forex is highly leveraged, much more so than a stock trading account. This is the first and foremost reason why the 2% rule makes no sense for the Forex trader or for any trader of highly-leveraged instruments. Let me elaborate…
Forex should be thought of as a margin account, because that is essentially what it is. In other words, you really only need to keep enough money in your trading account to cover the margin of the position sizes you normally trade…you don’t need to keep ALL your trading / risk capital in your trading account, any professional trader will tell you this. Since we are only in at most, a few positions at a time that we can use high leverage on, and we are only holding for typically a few days to one or two week maximum, we do not need to diversify our risk across many different markets, in other words, diversification in Forex is irrelevant.
Account size is arbitrary in Forex because a Forex account is only a margin account, it’s only there to make the deposit / have a deposit to hold a position. Nobody who understands these facts would put ALL their trading money in their trading account because it is simply not necessary. What you put in your trading account does not necessarily reflect all the income you have to trade and it does not reflect your overall net worth. In stock trading, you need a lot more money to control more money because there is less available leverage. Typically, if you want to control 100k worth of stock you need to have 100k in your account. Forex is much more leveraged as I’ve already said, and this means that to control say 100k of currency, which is about 1 standard lot, you only need around $5,000 in your trading account.
The rich guy and the poor guy
Whether you consider yourself “rich”, “poor” or “middle class”, there’s just no way that risking 2% of all your capital makes any sense. There is a skill factor involved with trading that varies widely from one trader to the next, given this fact, it makes no sense whatsoever that a new trader with only say 10k to his name should risk 2% of his account on any trade; he has no real trading skill yet and only 10k to his name; with the 2% rule, all he will do is lose money slowly, at best. You see, money management is dependent on both trading skill and personal risk tolerance, it should not be just some arbitrary percentage of your trading account.
Let’s say a guy in Singapore only has 10K to his name, that is all of his personal money, everything. If he follows the crowd and reads about the 2% rule on one of the many trading websites it can be found on, it means he will be risking $200 per trade (2% of 10K)! This is just totally ridiculous! The fact that so many traders are starting out with very little money to their name and they are told to risk 2% of all their trading money, really is borderline immoral. Skill levels and personal risk tolerance vary dramatically between traders, and this is another reason why the 2% rule is complete rubbish.
Conversely, let’s say a guy in Australia has 2 million dollars free to trade with, he is obviously not going to put all of that in his trading account, because he doesn’t need to. He may put 20k in his account just to cover the margins of the position sizes he normally trades. So if he uses the 2% rule, he is only going to start out risking $400 per trade, because 2% of 20k is 400. Does it make sense that someone with 2 million dollars of risk capital is only going to risk $400 per trade? If he is trading like a sniper as a swing trader in the Forex market (what I teach and how I trade), then no, it makes absolutely no sense at all. I hope you are starting to see why basing your risk per trade on 2% of the money in your trading account is simply irrelevant.
Thus, whether you have 10k to your name or 5 million, the 2% rule is pointless and even harmful if you are trading markets like Forex and others. It just does not make any sense and it does not apply to Forex like it might to longer-term stock investors.
Compounding is not what it seems
The big attraction to the 2% rule seems to be the notion that as you win trades and build your account, the money will compound and the 2% rule will naturally increase your position size, and conversely will decrease your position size as you lose. This sounds great in theory, but in reality it is really just a bunch of B.S. that is yet another reason why the 2% rule is a giant pile of rubbish…
The 2% rule is nothing more than propaganda spread by brokers to see you lose slowly, it helps you stay in the game longer… which is great for the broker because they collect more commissions and spreads. The 2% rule is really for losing traders to lose their money slowly…if you’re winning it’s not going to work to your advantage like it seems like it will in theory. What about drawing money to live on? If you really start doing well you are going to start withdrawing money from your trading account, so that pretty much sucks most of the wind out of the “compounding” theory. You cannot compound your trading profits in your trading account forever, it is not realistic or practical, forget about compounding.
Yes, 2% compounded will slowly increase over time, but you’ll be drawing on your money to live on, and original account size is arbitrary; the guy who has some serious money to trade who has only started off at 10k, when he gets confident he might dump 100k in his account…thus, what’s in the account is arbitrary…what’s important is managing your money properly and knowing how much you can risk per trade to stay in the game and stay profitable.
We’d all like to turn 10k into 1 million compounded, but it never happens like this. I’ll remind you that some of the greatest hedge funds of all time have drawn down up to 50% of their net worth on their equity curves. That just shows you the unpredictability of your equity curve. The compounding effect is stupid because it assumes you won’t have these hiccups in your trading, that’s why I prefer to bank the profits as I make them. Longer-term compounding is just for dreamers…
OK, so how much should I risk per trade Nial?
Your risk per trade is a very important dollar figure that YOU need to come up with based on your personal circumstances which will encompass a variety of different variables.
Quite a few of the pro traders that I know, as well as myself, never even think about the 2% rule or percentages…because we know it is irrelevant and because we know that there’s no mathematical advantage in thinking like that. Instead, we think in terms of dollars risked per trade and what our personal risk tolerance is; basically how much we are willing to risk on any one trade. We might have 1 million of trading money but will only have 50k in a Forex account. A lot of the margin in our account is used to hold a position and we don’t have a lot of extra money just sitting in there for no reason.
I get a lot of emails from traders asking me how much they “need to start trading live” or how much they should fund their accounts with. The answer I give to them is always basically the same:
1) You need to determine how much YOU are comfortable with having at risk at any one time in the market, and only risk THAT dollar amount or less. There’s no sure-fire way to determine this dollar figure besides a little trial and error and self-reflection. If you’ve risked an amount that causes you to remain preoccupied with your trade all day at work (constantly checking the market on your phone) and unable to sleep at night, then clearly you’ve risked too much. I know it might be sounding a bit cliché to any of my senior followers by now, but the best gauge to whether or not you’ve risked too much on a trade is whether or not you can truly set and forget the trade. You should not feel any urge to sit there staring at your charts after you enter a trade, if you feel that urge then you’ve probably risked more than you are comfortable with losing.
2) Obviously, your personal trading abilities come into play in determining how much you’ll be comfortable with risking per trade. If you’re relatively new or have just begun trading live, you’ll probably need to risk less per trade than someone with 10 years live account trading experience. As you improve and build your confidence you may feel more comfortable increasing your risk per trade a little bit.
As you can see, how much you should risk per trade is a somewhat personal question that requires some thought, time and trading experience to properly answer. It is not and should not be as easy as just saying, “Oh I will just risk 2% of my account, that sounds easy”. Money management is not easy, and anyone who tells you it is, is lying to you or doesn’t know what the hell they are talking about. Trading is the easy part of trading (does that make sense?)…money management and trader psychology (controlling yourself) are the hard parts!
MM and method are no good without each other
Just because you’re managing risk mechanically does not mean everything will “just” workout. Mainstream trading literature; websites, books, eBooks, all of these will have you believe that simply risking 1 or 2% will keep you in the game for the long term.
Whilst I agree that money management (MM) is crucial, you need to remember that if a trader was to draw down 50% of his first $1,000, he would then have to make 100% to get back to breakeven. Therefore, we’re missing a very important variable in this story…for any MM strategy to work, you still have to have a solid edge (solid trading method). There’s no point in having a good MM plan if your trading method is no good. Whether you use the 2% rule or fixed dollar risk, you’ll still blow up your account if you’re trading edge is not solid. MM should be thought of as a combination of trading method and money management, because money management alone won’t ‘save you’ or make you money in the market.
Whist the 2% rule may protect you as a beginner, you’ll probably never really move forward because you’ll be trading a very small amount…you have to up the ante and have confidence as your trading skill improves.
The 2% rule plays tricks with your mind
When people think to themselves “I’m only risk 2% per trade, that’s not too much, and it will decrease my position size as I lose”, it literally makes them less sensitive to the risk in the market and to the threat of account-destruction that results from over-trading.
When you lose decreasing amounts of money on every-trade it does something that many traders don’t think about; it makes you want to trade more because you keep thinking that you are “Losing less on every losing trade”. This is just a really stupid way to try and manage your money, and it clearly leads to gambling and over-trading. You don’t just stay in the market all the time because you are losing less and less money, this is no different than a gambler losing his gambling money at the casino.
Many day-traders and scalpers like the 2% rule because they trade with such high frequency that the 2% rule allows them to say in the game for a long time, usually just long enough to blow out their accounts, quit trading or realize that they should be trading higher time frames and with more patience.
Your risk per trade changes with skill, experience and confidence. It’s something you have to gauge. It is not something you automatically adjust up or down after every trade, as you do using the 2% rule.
At Learn To Trade The Market, it’s all about being frank with people; I don’t sugar-coat anything, and trust me, there’s a lot of sugar-coated B.S. floating around out there in the trading world, hoping to catch your interest (as you probably have figured out by now).
Remember, money management is no good without a high-probability trading method, and if you guys have been reading my blog for a while, you know I am a huge advocate of price action trading. Implementing a solid price action trading method with a sound MM plan is in my opinion, the quickest path to trading success. Despite this ‘recipe’ for success, there is NO sugar-coating it, you still have to put the study and effort in, and it will take time for you to turn the recipe into a masterpiece.
If you’d like learn how I harness solid money management with a professional trading strategy to achieve results, checkout my price action trading course and members’ community.