The 2% Rule
Most traders would agree that you should not risk more than 2% of your trading capital on a single trade. The stock market is mostly random. No one else is going to tell you this, but this is the reality of trading stocks.
So no matter how good the chart looks, there is a chance that the stock will not go in your desired direction and you WILL lose money on the trade. How much money will you lose if this happens?
On the first of each month, look at the total amount of money in your trading account. Let’s say you have $30,000 dollars. Two percent of this amount is $600.00. That is the maximum amount you can lose on a trade.
Position Sizing
Now let’s say that you see a stock that has pulled into the TAZ and is now trading at $25.00. It is looking like it is going to reverse so you decide that you are going to trade this stock. You first have to figure out where your stop is going to be. Do not think about how much money you can make on a trade, think about how much money you can lose if your wrong!
To keep track of my trades I use a trade management software program called Trade Trakker.
You determine that your stop is going to be at $24.00. So if you buy the stock at 25.00 and your stop is at $24.00 then your risk is $1.00 per share. Since you have already determined that the most you can risk on a trade is $600.00 then you can buy 600 shares of this stock.
This is because if you get stopped out you will lose $600.00, the maximum amount you are allowed to lose. Actually the number of shares that you buy should be a little less because you have to account for slippage and commissions.
By managing your money correctly on every trade you can relax because if you incur a loss it will be insignificant to your account. This will also relieve the emotional pitfalls that plaque so many traders.
This is only one trade! If you lose money on this trade, just move on to another. If you have a string of several losses in row either stop trading or reduce your position size to 1%.
