Traders today use a risk management method called the “1% risk rule,” or they slightly modify it to fit their trading styles. Adhering to this rule helps limit capital losses when a trader has a bad day or faces tough market conditions, while also allowing for significant monthly returns or income. The 1% risk rule is logical for many reasons, and you can benefit from understanding and using it as part of your trading strategy.
The 1% Risk Rule
Following the rule means you will not risk more than 1% of your account value on a single trade. This does not mean that if you have a trading account of $30,000, you can only buy $300 worth of shares, which is 1% of $30,000.
You can use your capital on a single trade, or even more if you use leverage. Implementing the 1% risk rule means you take risk management steps to prevent losses greater than 1% on any single trade.
No one wins on every trade, and the 1% risk rule helps protect traders’ capital from significant drawdowns in unfavorable conditions. If you risk 1% of your current account balance on each trade, you would need to lose 100 consecutive trades to deplete your account. If beginner traders adhered to the 1% risk rule, more of them would likely succeed during their first year of trading.
A 1% risk or less on each trade may seem like a small amount to some, but it can yield substantial returns. If you are risking 1%, you should also set a profit target or expectations on each successful trade at 1.5% to 2% or more. By making many trades in a day, a few percentage points can be achieved regularly on your account daily, even if you only win half of your trades.
Applying the Rule
By risking 1% of your account on a single trade, you can make a trade that returns 2% on your account, even though the market moved a fraction of a percent. Similarly, you can risk 1% of your account even if stock prices typically move by 5% or 0.5%. You can achieve this using targets and stop-loss orders.
You can use the rule for day trading stocks or other markets such as futures or forex. Suppose you want to buy a stock at $15, and you have an account worth $30,000. You look at the chart and see that the price recently set a short-term low at $14.90.
You place a stop-loss order at $14.89, which is one cent lower than the last low price. Once you have determined your stop-loss location, you can calculate the number of shares you can buy with a risk of no more than 1% of your account.
Your account risk equals 1% of $30,000, or $300. Your trade risk equals $0.11, which is calculated as the difference between the stock purchase price and the stop-loss price.
Divide your account risk by your trade risk to get the correct position size: $300 / $0.11 = 2,727 shares. Round this number to 2,700, which shows how many shares you can buy in this trade without exposing yourself to losses exceeding 1% of your account. Note that 2,700 shares at $15 cost $40,500, which exceeds your account balance of $30,000. Therefore, you need at least 2:1 leverage to make this trade.
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The stock price has reached your stop-loss level, and you will lose about 1% of your capital or approximately $300 in this case. However, if the price rises and you sell your shares at $15.22, you will make a profit of about 2% on your capital, or approximately $600 (excluding commissions). This happens because your position is calibrated to achieve or lose approximately 1% for every $0.11 the price moves. If you exit at $15.33, you will achieve a profit of around 3% on the trade, even though the price has only risen by about 2%.
This method allows you to adapt trades to all types of market conditions, whether volatile or calm, while still making a profit. The method also applies to all markets. Before trading, you should be aware of slippage where you might not be able to exit at the specified stop-loss price and could incur a larger loss than expected.
Percentage Differences
Account traders trading with less than $100,000 typically use the 1% risk rule. While a 1% risk offers more safety, once you are consistently profitable, some traders use a 2% risk rule, risking 2% of their account’s value on each trade. A middle ground could be risking 1.5% or any other percentage below 2%.
For accounts over $100,000, many traders risk less than 1%. For example, they might risk 0.5% or even 0.1% on a large account. When trading short-term, it becomes difficult to risk even 1% because the position sizes become too large. Every trader finds a percentage they feel comfortable with and that fits the market liquidity they are trading in. Whatever percentage you choose, it should remain below 2%.
Loss Tolerance
The 1% risk rule can be adjusted to fit the trader’s account size and the market. Determine the percentage you feel comfortable risking, and then calculate your position size for each trade based on the entry price and stop-loss.
Following the 1% risk rule means you can withstand a long streak of losses. Suppose you have larger winning trades than losing ones; you will find that your capital does not decrease rapidly, but it can increase relatively quickly. Before risking any money – even 1% – practice your strategy in a demo account and work on achieving consistent profits before investing real capital.
Frequently Asked Questions
How do you use risk management when trading on Nadex?
Binary options on Nadex are yes/no contracts, so most risk management should be done before buying the option. Once you are in the trade, you can close the trade to limit losses.
Why are some trading strategies riskier than others?
Generally, the higher the risk in a trade, the higher the potential returns. Options that are out of the money (OTM) are less likely to expire at the strike price – they are riskier. However, if the price reaches the strike price, a trader who bought a safe in-the-money option will see a higher return rate than the trader who bought an out-of-the-money option. This is just one example to illustrate the common relationship between risk and reward.
Source: https://www.thebalancemoney.com/day-traders-stick-to-the-1percent-risk-rule-1030858
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