About Risk Management and the 2% Rule

Discussion in 'Ask any question!' started by Christopher Davis, May 15, 2020.

  1. Christopher Davis

    Christopher Davis New Member

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    Hi, newbie here, in my early stages of trading self-education.

    Regarding account risk management and the 2% rule and what it actually looks like in practice. I'll just quote from one source I'm reading: "...the rule of thumb that says you should not put more than 2% of your capital at risk on any one trade. So if you have $20,000 of capital in your account, you should not put more than $400 at risk on a trade."

    My question: What precisely is the "capital" part?

    Let's say I have in my account $20,000 of various stocks, and $5,000 in cash. Is my capital the total $25,000? Or is it just the $5,000 cash? Do I count all my positions as my capital, the total current value of my account? Or is it just my free cash I have to invest?

    Thanks much for any guidance!
     
  2. Stoch

    Stoch Well-Known Member

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    The capital is the account size, in this case $25000. the 2% is the risk of the trade, that would mean you could invest $500 in a trade with no stop, or you could invest the whole $25000 in 1 stock, but would need a tight stop to limit the loss to $500
     
  3. Christopher Davis

    Christopher Davis New Member

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    That's what I needed to hear. When you are new and you read this rule it doesn't automatically make sense how to actually apply it. But I am going through that now. I wasn't clear if capital included your current positions, because that can fluctuate and is not "liquid" at that moment. But I get it now, I guess it does include that. Thank you.
     
  4. The Brontide

    The Brontide Active Member

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    I know that rule, but I do not believe in it wholeheartedly.

    I prefer risk tolerance management.
    Apply the 2% rule to my 401k sure.

    But I have much more risk tolerance for side investments that have the potential for higher rewards.

    I guess the reason for me is that I do in fact limit myself to one, two, or three focused companies that I monitor in depth. I do not like to manage too much of a portfolio, and yes that always means maximum capital gains tax.
     
  5. Christopher Davis

    Christopher Davis New Member

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    I understand what you're saying. That was one of the exceptions I also read about, when you're comfortable adjusting the rule. I can definitely see when the confidence or circumstances of a trade are different you might be ok risking more. 2% is a good place to start though for structure and discipline. Thanks
     
  6. Christopher Davis

    Christopher Davis New Member

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    If you are estimating the loss per share, is that a strict calculation or just a comfort level guess?
    For example, a stock is trading at $10. It looks like it could go up to 12 soon. But it also looks like there is some support at 9.25. So it might go down. How accurate are your calculations on the bottom support of 9.25? It seems like a good level to get out just from a random perspective too. Because it could go down much further, or possibly not as much. So you use that .75 as your stop loss.

    Maybe a little off topic but, lastly, how quickly do you have to figure this out? I notice that when I buy shares I'm trying to place a Limit order for whatever the Ask is, but the Ask shifts up and down literally every split second. I don't get how that works.
     
  7. Stoch

    Stoch Well-Known Member

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    Its just a general estimate that you can do rather quickly. Lets say you had $1000 and the stock was trading at $10. Your risk limit would be a $20 loss. You could buy 100 shares and your stop loss would be at $9.80, or you buy 50 shares with a stop loss of $9.60, or buy 20 shares with a stop of $9.00. If you start with the maximum loss, say $9.00 for the support you expected at $9.25 (give it some wiggle room so you don't get stopped on a brief penetration and then watch it reverse as you expected), you could buy the 20 shares and watch the trade develop. I like the saying to draw support, resistance and trend lines with a crayon, not a pen. That give you some leeway on both sides to decide what is happening.

    As for the bid/ask, try placing the bid just a few cents above the ask if the spread is narrow, the routing of the order will try and get the best fill and you may even get a better price then when you placed it. Its a little more difficult when the spread is larger, say 20 cents or more. Then I either split the difference or see what the last fill price was and use that. Otherwise you can place it at your price a wait a few minutes to see if it comes in. I just think Its not worth missing a trade for a few pennies.
     
    B Russ and T0rm3nted like this.
  8. Christopher Davis

    Christopher Davis New Member

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    Thank you so much. A lot to take in.
     

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