The risk management in day trading usually follows the same pattern or line of thought. Very often it is some sort of the “one percent rule”
It is a rules-based scheme that stipulates that no more than one per cent of your account should be devoted to any specific trade. It is achieved with a view of managing capital prudently and reducing losses.
The “one percent law” guarantees that the “off days” of a trader, or situations where the market goes against the account’s trades, do not affect the portfolio more than it should.
Good day trading risk management is a crucial skill. And part of what achieving long-term growth means is minimizing material capital losses.
If you’ve got a 50 percent drawdown, that means you need a 100 percent benefit just to get back to breakeven. On the flip side, if you lose just 10 percent – preferably over a period spanning several months, not days or weeks (which would signify weak risk management or maybe bad luck) – you only need an 11.1 percent return to breakeven again.
You will note that this relationship functions in steeping non-linear manner, as opposed in a linear way.
It is imperative that you keep your losses small. When losses worsen, psychology starts playing more of a role, and often in an adverse way. Traders begin to make bad decisions, and can spiral into a scenario of “risk of ruin.”
Everything is a chance. In line with this, you want to stop risking too much on any one event, because there’s a chance it’s going to go against you. The general strategy in trading or more general investing is to make several uncorrelated bets where the risk is in your favor. You’ll be good if you can conduct this.
One Percent Rule Example
For day traders, the one percent rule means you should never lose more than one percent of your account value at any given position. Often this one pe cent means equity, not borrowed money. However, this can be used to add leverage, but the loss is stopped immediately if it reaches one percent of the account’s net liquidation value.
For example, if you have a $20,000 account, this means any one of the following:
(1) No place can exceed one percent of the account value, even if it includes borrowed money. In other words, the place must be limited to $200 in stock, forex or whatever resource is exchanged.
(2) Leverage can also be used in such a way that the value of the position exceeds $200. But the trade stop-loss is set so that the monetary loss can not surpass it.
For eg, if you take a $800 position, your stop-loss will never exceed a market value drop of 25 percent (25 percent * $800 = $200), or a value equal to 1 percent of your account’s net liquidation value.
How to Apply the One Percent Rule
You can determine how to implement the one percent rule ahead of time using stop-losses and take-profit rates.
Let’s assume a stock that you have a trading interest in is valued at $20.00.
You want $19.90 for the stock to go long. Your take-profit is $20.05. Your stop-loss is $19.85 and the account is valued at $20,000.
How many shares should you potentially buy in this stock to keep the one percent rule in place?
Primarily, decide how much you are entitled to lose in any given trade:
$20,000 * 1 percent = $200
The maximum loss you can get per share is the difference between where you get in and where your stop-loss is. The difference in this case is $0.05 ($19.90 – $19.85).
Then take the maximum loss amount and divide it by the maximum loss per share:
$200/$0.05/share = 4,000 shares.
Thus, if the broker allows up to that amount of buying power, you can purchase up to 4,000 shares of that stock. (In this particular case you will need a leverage ratio of 4:1) Because your loss is limited to just $0.05 per share, your overall loss is held within your parameters.
Things to Keep in Mind
Although, you would want to order a smaller number of shares to compensate for this because to order slippage, where orders don’t always fill at the same price you want. Slippage means that the threshold of the one percent loss is likely to be surpassed.
Additionally, if you’re planning to hold several positions – or are doing so – you’ll need to cut down on how many shares you’re going to trade in order to have money available for them.
Exceptions From the One Percent Rule
Exceptions from the one percent rule are based on market liquidity in which you trade. When you trade a liquid stock – typically the higher the market capitalization the more liquid the stock will be – there will be no difficulty taking orders of $10,000-$100,000. (And obviously if you’re just starting out, you’re not going to be moving close to those rates of capital.)
For markets that aren’t liquid, like some futures markets or low-volume periods in others, having bigger orders through will turn the market against you. After all, the operation which moves markets is buying and selling. And in some situations it can be you acting as the buyer or seller.
For larger accounts, which are trading larger positions in the six-figure range and upwards, they may actually go below the one percent rule to the half-percent rule or similar.
If you take positions in very liquid markets, such as large cap stocks, this isn’t a issue until the share sizes are in the millions of dollars, but it could be a different story in a small-cap stock, an exotic currency pair, or a thinly traded futures market.
But whatever the case, day traders are unwise to gamble more than around one percent of their account on any deal.
The one pe cent rule can be tailored in day trading risk management to suit the expectations or needs of each individual trader depending on the markets they trade and the size of the positions traded. You can measure this amount using your entry price and stop-loss, realizing you can sell X amount of a protection and take so much loss before your risk management rule takes you out of the traded market.
This would preferably be no more than around one percent. But even though one were to suffer ten losing trades in a row, it would just be a ten percent drawdown, which can be handled.
In fact, if your winning trades are greater than your losing trades, then you’ll find your account has the ability to rise faster than it goes down. At the same time, even though you follow this rule correctly but your account still bleeds steadily in value, it might be time to rethink your plan and analytical approach to the markets that you trade.
The ultimate indication of if you transact too much is when it emotionally affects you.
Do you always look at and absorb the maps, just watching the change in price? Do you perform similar needless and unproductive conducts?
Will the trade make you nervous or anxious?
Do you feel irritated when the market is moving against you (rather than thinking rationally what causes the move)? Do you feel pleased or relaxed when the market is moving in your favor?
Will the markets keep you up at night if you hold positions overnight?
If you answer yes to all of the above, you’re over-trading. All exchange is esentially a business decision. Sticking to the rules for any given trade helps to reinforce the mechanism required to bring about successful results.