1% Risk Rule in Day Trading
In this article, we’ll break down this simple yet effective risk management strategy and show how a portfolio manager can use it in his daily financial operations.
A small note before we begin: there is another “one percent rule” in real estate investing, but this article is about the 1% rule in risk and capital management.
Table of Contents
What is One Percent Risk Rule?
This rule refers to a method of trading where you never bet more than 1% of your total bank on a single deal. This simple strategy saves an investor from fast and painful financial losses.
The 1% Rule doesn’t mean that an investor with $100,000 on his trading account can use only $1000 (1%) for each buy or sell operation. This rule means that he shouldn’t risk more than 1% ($1000 in our case) per one deal, but he can bet more than 1% of his capital and even use some financial leverage to increase potential revenues. This rule states that if an investor wants to open a position, he should also place a stop-loss order on $1000 total losses and automatically close the position as soon as it happens.
Why is it Smart to Set Up a Trade Limit?
The 1-Percent Rule is, technically speaking, not a rule at all. It’s just a common concept accepted by some active traders but there is no general rule or law that enforces it. Many investors would set up a different trade limit for themselves: for an experienced trader the limit of possible losses might be 2-4% of the total capital per trade, but for a beginner, it might be just 0.5%. The point is to limit yourself and to avoid significant losses on a single deal, yet the borderline of that limit may vary.
Nobody is perfect and all of us make mistakes, but people who’re involved in stock trading are especially at risk as their mistakes are literally costly. Note that this 1% rule is often mentioned only for day traders, meaning that those who make 10, 100, or even 1000+ trade deals every day are particularly at risk. Those active traders have to be able to afford losses and make some mistakes as they are in the business for the long term, so they can’t risk more than 5-10% with just a single trade, even if they’re 100% sure that they caught a great financial opportunity. They have to have enough equity to recover after a mistake.
For passive and conservative investors a similar rule can apply, which would limit the amount of money they spend on one investment. Although, in their case, a similar rule would be close to the general concept of diversification. The 1% rule is quite close to the diversification strategy as the diversification requires the total capital to be invested in different assets, which can’t be done if a portfolio manager bets everything on a single deal.
Setting up a loss limit is also important from a phycological point of view. Strict self-control and risk management strategy can help an individual to stay focused, calm, and sharp even after suffering losses. A trader without such a strategy might want to gamble his losses back right after the mistake. This emotional response often leads to something that poker players call “tilt”, which is a kind of a cognitive bias.
How to Apply the 1% Risk Rule? Example
The 1% rule states that you can’t risk more than 1% of your account value on a single trade deal, but it doesn’t say that you have to always bet 1% of your bank! This part may seem a little bit confusing, so we’ll clarify it with an example:
Let’s assume that you have $40,000 of capital and you’ve decided to start investing actively.
If you purchase Apple stock at a price of $200, this rule doesn’t say that you can buy only 2 shares (40,000 * 0.01 = 400 and 400 / 200 = 2) at a time.
The 1% rule simply says that you should close the position if your losses exceed $400 (1%). Therefore, all you have to do is to figure out where to place a stop-loss order.
We’ll assume that you decided to invest 10% of your free capital in Apple stock, this is $4,000. With this money, you bought 20 shares at $200 each. So, at which price should you place a stop-loss order?
If the price goes down by $2 (-1%), you are losing $40 with your 20 shares, thus your loss limit would be 10 times that (400 / 40 = 10), which is -$20 from the current price.
So, you should place your stop-loss order (sell) at $180.
As soon as the price drops from $200 to $180, you’d lose $400 of value, which equals to 1% of your total bank and the stop-loss order will be immediately executed to prevent further losses.
The 1% rule mechanics is quite simple and easy to understand. With some experience you can learn how to calculate this limit in just a minute, even without using a calculator.
Your Capital and its Limitations
Continuing with the previous example, let’s imagine a case where you only have half of the capital from the previous example - $20,000. How’d it change the trading strategy?
Well, your safety limits are halved now, therefore you would place the stop-loss order at $190 instead of $180. This makes you more vulnerable and sensitive when you deal with volatile assets. It’s quite common to expect that a price would go up by, say, 5%, but before that, it could fall by 6% for a short period of time. This downfall of 6% would close your deal with a 6% loss if you had $20,000 in your trading account, but if you have deeper pockets, this small movement wouldn’t force you to close the position and you’d end up making that 5% afterward. A small capital limits your market opportunities, not to mention that, in some cases, small equity can result in a forced margin call which would wipe out all of your money.
Use More Than One Rule
The 1% rule is not the only rule you might consider to use. It’s a nice addition to other signals like support and resistance price levels in technical analysis, historical price levels, professional advice, etc.
For instance, if a 10-year low of stock was at $100 but the 1% rule tells you that you should place your stop-loss order at $90, perhaps you should reconsider using the 1% rule in this case and place the stop-loss at $100. Some flexibility can help in cases when you have a stronger signal that overrules it.
You can develop a unique, personal and complicated strategy that may include a number of “rules”.
What is the Opposite of 1-Percent Rule?
If there is a rule which limits your losses on a single deal, there must be a rule about taking your profits. Many inexperienced traders don’t understand that you should not only limit your losses but also know when you should close the deal to collect your profit. It’s a dangerous approach to just wait and actively track the price as it’s already above the profit level, but so many active investors are guilty of it.
Common thinking would be like:
“Well, if it's passed the profitability line already, let it go a bit more and then I'd sell it”
This is greed talking and it’s better to ignore its voice.
A wise strategy would be to set up a 1/2% rule or something like that. This would mean that you can lose 1% of your capital, but you make 2% off one deal at the same time, if you made the right call.
With such a strategy all you have to do is to be right 33 times of 100 in order to break even.
There are many different approaches and some would even suggest sticking to 5/10% rule (5% losses, 10% gains of the total bank on a deal), but this is really risky for an active daily trader or a beginner. Such huge investments should be considered only for a long-term investments of 1, 3, 5, or even 10+ years.
In any case, it’s a wise idea to determine not only a moment when you should accept your losses and close the deal but also a moment when you stop your greed and get your fair reward.
When Should I Use 1% rule?
The Balance.com, Investopedia and some other sources say that the 1% rule is often used by traders with the capital of less than $100,000. Those with an account over this sum often risk a smaller or a bigger percent of their money (0.1, 0.5, 2 or even 3%) with a single deal.
Learn From Your Mistakes
The 1% rule is great for those who make their first steps trading because it allows a beginning portfolio manager to learn from his/her mistakes. At some point, you would stop trading on a virtual account with “fake money” and open a real account so you can finally experience the market as is.
When you start your journey as a trader, the key thing is to survive in the market for as long as you can, thus you have to stick to the 1% rule to be able to have some losses and still stay in the game. It’s much better for a beginner to make 1000 trades, even with a low success rate, than to make just a few deals. Each real money trade brings a valuable lesson, so it’s good to experience as many of those trades as possible. The 1% rule will give you the opportunity to make at least 100 deals on the real market, even if all of them would be unsuccessful (which is impossible).
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