2% or not 2%

We should all know the 2% rule. Devised by Dr Alex Elder. Says capital risked per trade should be not more than 2% of your total account.

I have followed this rule and quoted it here and elsewhere. My own current trades are running at about 3% risk on average - I'm not a novice but still conservative and still trying to respect the rule. But we shouldn't give unquestioning faith to any rule in trading.

First off, this rule first appeared in print no less than 23 years ago in "Trading for a Living", by Dr Elder. His name started to become known in the late 80's. His trading obviously pre-dates the launch of his website in 1988. That passage of time on its own should qualify for this to be re-visited.

Dr Elder is a psychiatrist who trades. Nothing wrong with that, but he is bound to bring a psychological viewpoint to his writings. It's therefore very possible that the major benefits of following his teachings are protection from negative psychological impact, rather than wealth generation.

Dr Elder's knowledge and experience in trading are derived from the US private trader's viewpoint. This is not necessarily going to be universally reflected by traders' conditions in other countries.

His experience pre-dates the huge increase in private trading in the late 1990's. I don't say good trading rules should have come out of the frenzied daytrading of the tech bubble, those were atypical market conditions, but some things in the game have changed since then.

His experience was (I think) derived from going long on US stocks in the late stages of a decades-long bull stock market and US economic expansion. As far as the markets were concerned then, I'm sure the feeling was this was never going to end. But being a long-only one-country share-buyer probably doesn't count as trading as we now understand it. How relevant is buying shares in a bull market to trading both ways on the huge variety of other instruments we can now access?

Sorry if I've taken a swing at your personal guru, but I suspect those of us who know the rule also break it every trade. Don't you?

I think his books are aimed at the novice trader and once you gain experience you'll do your own thing regardless of what any guru tells you in their 'new book'. He's just setting out a prescriptive money and risk management strategy for the neophyte and 2% isn't a bad starting point regardless of instrument or T/F IMHO

Interesting comments with which I empathise. The 2% rule is okay if you have a large amount of capital – in which case your 2% would probably be much less. The problem arises for the average starter trader who I suspect has considerably less capital. In this situation the only way to trade your way to substantially increased capital within a reasonable timescale, is to risk considerably more than 2%. So what should you do? My suggestion (and what I am currently doing as an experiment over and above my risk-conventional trading) is to find a trading methodology which has a high probability of success and use that in conjunction with stakes higher than the 2% rule.

I tried this in paper format over about 6 months to ensure the viability of the methodology and have just completed the 1st 5 weeks of trading for real. With 11 wins and 2 losers this has been considerably more successful than I expected with approximately 40% gain. Now of course, we are on a good trending upmarket on the S&P 500 and my situation may well be just a lucky snapshot, but I do believe nevertheless that because my basic methodology is simple (just find a good uptrending stock that appears to be stuck in an upwards rut and jump on board, and get out when you've got some profit) there may be some merit. Before I started I would have been pleased to make 10% per month which with compounding could soon turn your capital in to a respectable amount. E.G. you could turn £1500 into almost 5000 in a year if you can make 10% per month.

Anyway, those are my thoughts and they reinforce my contention that a simple, basic and sound system is probably more important than all the fancy brain- hurting equations and systems that are sometimes purported to be the only way to profitability.

PS. I should add that one of the significant advantages of trading a small capital amount is that you can't actually lose very much (Guaranteed stops are very useful, and if as is sensible, you are only using money that you can afford to lose) there is little psychological pressure. E.G. Trading an SB of 0.24 points on the SP 500 might typically give you a loss of £20-£30 at some stage of the trade; if you are trading higher stakes would you be psychologically able to handle a temporary loss of say £400 without bottling out? Once the psychological pressures start building, things can change considerably.

tomorton said:

We should all know the 2% rule. Devised by Dr Alex Elder. Says capital risked per trade should be not more than 2% of your total account.

I have followed this rule and quoted it here and elsewhere. My own current trades are running at about 3% risk on average - I'm not a novice but still conservative and still trying to respect the rule. But we shouldn't give unquestioning faith to any rule in trading.

First off, this rule first appeared in print no less than 23 years ago in "Trading for a Living", by Dr Elder. His name started to become known in the late 80's. His trading obviously pre-dates the launch of his website in 1988. That passage of time on its own should qualify for this to be re-visited.

Dr Elder is a psychiatrist who trades. Nothing wrong with that, but he is bound to bring a psychological viewpoint to his writings. It's therefore very possible that the major benefits of following his teachings are protection from negative psychological impact, rather than wealth generation.

Dr Elder's knowledge and experience in trading are derived from the US private trader's viewpoint. This is not necessarily going to be universally reflected by traders' conditions in other countries.

His experience pre-dates the huge increase in private trading in the late 1990's. I don't say good trading rules should have come out of the frenzied daytrading of the tech bubble, those were atypical market conditions, but some things in the game have changed since then.

His experience was (I think) derived from going long on US stocks in the late stages of a decades-long bull stock market and US economic expansion. As far as the markets were concerned then, I'm sure the feeling was this was never going to end. But being a long-only one-country share-buyer probably doesn't count as trading as we now understand it. How relevant is buying shares in a bull market to trading both ways on the huge variety of other instruments we can now access?

Sorry if I've taken a swing at your personal guru, but I suspect those of us who know the rule also break it every trade. Don't you?

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Read his books many years back. Not bad, certainly entertaining. Effective? I doubt about that.

The -1-2-3% rule ? Pure BS in my view. That is what is killing 90% of traders.

Fugazsy said:

Read his books many years back. Not bad, certainly entertaining. Effective? I doubt about that.

The -1-2-3% rule ? Pure BS in my view. That is what is killing 90% of traders.

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Why do you say that ?

1-2% is a decent starting point for inexperienced traders that will be losing their shirt anyway first few years .........at least they stay in game for longer ..........

I still tend to stick to it per trade..........just habit I guess.......overloading % capital into a market position based on ones own (subjective) abilities and expectations of outcome can be a very foolish game in the long term .........

N

Fugazsy said:

Read his books many years back. Not bad, certainly entertaining. Effective? I doubt about that.

The -1-2-3% rule ? Pure BS in my view. That is what is killing 90% of traders.

Click to expand...

whats killing 90%+ of traders is that they are Cr*p traders .....the % capital applied just decides the cull rate

N

Some good posts here, I have learnt the hard way (who hasn't) about mm. Personally I only hold a fraction (5%) of my trading funds in the broker account and hence regularly risk more than 2% of that account on trades to get a decent return on that. With my system I have entry and exit zones scaling in and out, once it gets outside the zone and the trade is wrong I will cut it, also if price spikes massively for some reason and you get a margin call you never take the call - that's a line in the sand. You take the hit and move on therefore only ever risking 5% of your total trading capital ever in the relatively rare circumstances where price gaps massively (I use stops but not guaranteed, not worth the extra cost in my opinion).
Everyone has to sort a mm system for themselves that does not psych them out trading but delivers profits and manages losses in a sustainable way imho.

In some shape or form you must control losses and be able to stand an extended run of losses without fatal damage to your account (losing 50% of your account means you have to gain 100% with what remains just to get back to where you started).

2% is as good a rule of thumb as any.

Pat494 said:

Why do you say that ?

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I will try my best to explain...

The traditional literature idea of risking 2% per trade placing an hard stop close to the market hoping a better 1:2 or better is an false information/education.

Market does not have to do anything and with an hard stop you can be right and lose money and the 2% is gone which will be adding to the 4 % already lost and you find your moods under your feet, here you will start to look for the holy grail or next guru (where is Tar?) because what ever you do it will not work...does it sound familiar?

Trades needs space to breath despite any length of knowledge of TA a trader has attained, if we do not give that space our trading will be under strain, it will not be flawless, which is an essential part in moving a step above in the trading arena.

Hoping to gain with consistency a greater RR with every trade is also part of that distorted literature, again market can do anything from the moment we take the trade and the response can be various and the 2% set of our risk can influence us when we are taken profit if it ever goes to positive.

The solution?

The solution can be various, for example I can risk 1/10 of that 2% per trade and trade numerous instruments and not have any hard stop at all and martingale at the next resistances levels if my initial trade was a short and so on... or set a limit of risk when to get out if continues in the wrong direction.... I can be wrong and make money, often is best to be wrong first...

It does not matter what a trade does I can make money either way, my % of winning trades is high, yes my losing trades are larger but few...

If I do not martingale I can hedge on a bigger time frame and liquidate when and if my initial trade goes back into positive, I will have numerous account and I do not care if a few accounts will pulverise because I making it up in my other accounts.

A trader needs to create a method based on his own risk tolerance.

It depends if you are swing trading or scalping , risking more than 2% in scalping may kill you , at the end it is just a rule of thumb , surely you may risk more than 2% .

Other factor traders should be aware of is try to understand where pending orders are sitting, here traders are taken profits and others are waiting to get in, waiting for a confirmation can be too late, the time it is confirmed many have already taken profits....

a trader needs always to take in consideration market conditions, using a martingale module in a trending market is not such a great idea but in a range market which are 70% of the time is not bad at all.

Also, remember risking (say 2%) doesn't mean losing (2%) when factoring in losing trades when forward projecting a sequence of results, or indeed analysing past results. (ie we don't just let stops be hit for the sake of losing)

2% is just the "initial risk", and this all changes once we are in the trade based on price movement/order flow.

Bottom line - just because the trade doesn't work out - the result does not have to mean a loss of 2%

So 5 losers in a row should not mean -10%, if it does then you are not trading price/time, you are just a sitting duck.

Problem is that most literature written by academics is too black/white, left/right. Real trading/real life is not like this, only experience will make this become clear.

tar said:

It depends if you are swing trading or scalping , risking more than 2% in scalping may kill you , at the end it is just a rule of thumb , surely you may risk more than 2% .

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Well that's one of my points on Elder's rule - he surely didn't mean daytraders should take 2% risk per trade.

barjon said:

In some shape or form you must control losses and be able to stand an extended run of losses without fatal damage to your account (losing 50% of your account means you have to gain 100% with what remains just to get back to where you started).

2% is as good a rule of thumb as any.

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Cheers Jon, this relates back to Elder's original trading model. An extended run of losses on long positions would most commonly be triggered by a rotation of the underlying bull market into a bear phase. Elder was writing for medium-term traders who were going long only, so even fantastically good portfolio management and stock picking couldn't protect them from a bear market. A much more likely event than a black swan.

But we're able to go long and short on instruments in the same class, so a rotation from bull to bear isn't to us what it was to him and his original readers. And its the original readers he was writing for, buyers of his book who were active in the 1993-4 stock market, not some guys in another country 20 years later using spreadbetting and goodness knows what else.

Surely for long-only EOD traders 2% might be prudent, but long-and-short traders should double it to 4% at least? And that's assuming the rule is even correct, which I'm not convinced now that it ever was.

Who is on on the other side of 2%

tomorton said:

Cheers Jon, this relates back to Elder's original trading model. An extended run of losses on long positions would most commonly be triggered by a rotation of the underlying bull market into a bear phase. Elder was writing for medium-term traders who were going long only, so even fantastically good portfolio management and stock picking couldn't protect them from a bear market. A much more likely event than a black swan.

But we're able to go long and short on instruments in the same class, so a rotation from bull to bear isn't to us what it was to him and his original readers. And its the original readers he was writing for, buyers of his book who were active in the 1993-4 stock market, not some guys in another country 20 years later using spreadbetting and goodness knows what else.

Surely for long-only EOD traders 2% might be prudent, but long-and-short traders should double it to 4% at least? And that's assuming the rule is even correct, which I'm not convinced now that it ever was.

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Well, I can trade both ways but that didn't stop me having a losing run of 9 earlier in the year.

I don't think you can say whether the rule is "correct" or not, it's just a rule of thumb that gives you a decent chance of staying in the game a lot longer than you might. In trading contests the winners have often gone "all in" most of the time and scored untold paper riches. For the one lucky "all inner" ther are 99 who have blown out of course

People, particularly beginners, often concentrate on how much they can win (hence not liking a low stake/low risk rule) whereas the longer toothed focus on what they can lose and control that.

barjon said:

Well, I can trade both ways but that didn't stop me having a losing run of 9 earlier in the year.

I don't think you can say whether the rule is "correct" or not, it's just a rule of thumb that gives you a decent chance of staying in the game a lot longer than you might. In trading contests the winners have often gone "all in" most of the time and scored untold paper riches. For the one lucky "all inner" ther are 99 who have blown out of course

People, particularly beginners, often concentrate on how much they can win (hence not liking a low stake/low risk rule) whereas the longer toothed focus on what they can lose and control that.

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Indeed Jon, going all-in and hoping for luck just isn't risk management. So I guess some form of risk management has to apply, somewhere less than 100% risk per trade. But I'm saying acceptance of 2 is just wrong.

I've got a feeling that Elder was thinking to himself, "Whether I make money trading or not, I want people to buy my book. And my name will be mud if they buy it and go bust." So this has conditioned his rules. He's gone really conservative so that it can be argued anyone who goes bust after following his rules must have just been terribly unlucky, and that's nobody's fault. And I suspect he's also thought to himself that if the bull market ends before his readers had a chance to re-coup their losses, at least they'd have enough money left to transfer it to an interest-paying deposit account. His long-only readers couldn't trade in a bear market but they would still want to make money and hold the ambition to get back into the market.

So he's conditioned them to "not lose" or at any rate to "not lose fast" rather than to win. Alright, as a new trader, preservation of capital is key. But a 2% cap isn't from the real world, its from the unproven author's world. And for experienced traders, surely 2% is suicide?

The crime here isn't the advice, its the blind acceptance, and I admit to being an accessory here.

Agree with much of what has been said.

I would add along with the MM system of 2% Risk / x% Reward???

One must also consider:

- ATR of instrument
- Volatility
- TF and
- Type of trade entered ie. scalp or swing


Alternatively, if we are sticking to the 2% risk rule then make sure instruments selected for trade lend them selves favourably to such a rule & TF. Not all instruments move the same.