The simplest and most effective way to protect your equity through risk management is to establish strict loss parameters and abide by them. One popular method is the 2% Rule, which means you never put more than 2% of your account equity at risk (Table 1).
For example, if you are trading a $50,000 account, and you choose a risk management stop loss of 2%, you could risk up to $1,000 on any given trade. The powerful beauty of this rule is that if you strictly adhere to it, you would have to make dozens of consecutive 2% losing trades in order to lose all the money in your account. Even for a new trader, this is highly unlikely.
Although often used by traders, the 2% threshold is completely arbitrary. You certainly could operate with tighter or looser parameters. But, in order to manage your risk effectively, you need to choose a level that makes you feel comfortable and stick with it.
|Account Size||Risk Management Stop Loss||Maximum Loss|
The 2% Rule also creates a structure for your trading decisions, as illustrated in Table 2. For example, assuming you have a $50,000 account and you want to buy 5 Canadian Dollar contracts, the 2% Rule tells you that you could risk no more than 20 ticks on the trade (5 contracts x $10/tick x 20 ticks = $1,000). If you wanted to operate with a more liberal 50-tick stop, you could only buy 2 contracts. Similarly, if you wanted to buy a larger position, say 20 contracts, you could risk no more than a scant 5 ticks.
Using the stop-loss threshold in conjunction with a predetermined risk/reward ratio also can help you establish exit points on your profitable trades. For example, assuming a 2:1 risk/reward-ratio, if you are risking 20 ticks on your 5 Canadian Dollar contracts, you should be looking to make 40 points, thereby making $2,000 if the market goes your way and only losing $1,000 if you get stopped out.
|2% Rule and 2:1 Risk - Reward Ratio|
|Account Size||Maximum Loss Assuming 2% Stop Loss||Number of Contracts||Number of Ticks That Can Be Risked ($10/tick)||Profit Exit Point Assuming 2:1 Risk Ratio|