The 2 percent rule is a powerful tool in trading. By adopting this
rule you`re using a strategy that decreases the size of your losses during
losing streaks, an important consideration. There is, however one small
caveat that you need to be aware of when using the 2 percent rule to calculate
how many shares you are going to buy. As you know, the number of shares
you can purchase is determined by your maximum loss and the size of your
stop. Which means that by increasing your risk, you can also increase
the dollar value of the position you open. Or, by simply shrinking your
stop size, that is by setting a tighter stop loss, you can increase the
dollar value of the position you open.
To avoid a situation where you could end up with excessively large positions
that may put your trading float at risk, you can choose to introduce an
extra rule. This rule would limit the dollar value of a position to be
no more than a set percentage of your entire trading float.
For example, you might decide that you`ll never open a position that
has a dollar value of more than 25 percent of your entire trading float.
This rule would only be executed if, after calculating the formula that
determines how many shares you buy, you find the dollar value of that
position would greater than 25 percent of your float. If this happened,
you would scale down the position to make sure it did not exceed that
25 percent.
The percentage brthat you decide upon will depend on the type of system
you`re trading, the size of your float, and your personal tolerance for
risk. Generally, smaller trading floats might use 25 percent, and larger
trading floats might use as little as 10 percent or even 5 percent. There
are no definitive numbers, and the percentage that you choose will depend
on your personal circumstances.
Once this tendency is corrected for you will have all your money management
rules in place, ready to control your risk. Now you need to take the next
step. Test your system to find out which of the variables best suit you,
remembering always that position sizing is the most significant part of
any system design. It is the lynch-pin of money management. Once you`ve
tested your system, and fine-tuned your rules, you will be well on your
way to becoming a successful trader.
