The 5% Money Management Rule

By Richard Krivo, Trading Instructor

21 October 2010 21:51 GMT 

Student’s Question:

I've read somewhere that you should risk no more than 5% per trade. I've been trading 3% per trade and probably open 4 positions a day. So I've been risking 12% per day. Listening to one of your webinars on this 5% topic, should I then risk 1.25% per trade (5% in total)? I was always under the impression that "no more than 5% per trade" meant every trade you open should not be risking more than 5% of your account.eg. $1000: 1st trade: can risk $50, 2nd trade (first trade still open): can still risk $50, etc.

Instructor’s Response:

The 5% rule pertains to the TOTAL amount of the account balance at risk at any one time...NOT on any individual trade. So, if you have one trade open, 5% is the maximum allowable risk. If you have two trades open it would 2.5% per trade and so forth. Think of it this way, if it were 5% per trade, a trader could open five trades risking 5% on each trade and still be within the rules. What would prevent a trader from opening up ten trades and only risking 5% on each one? There has to be something that prevents the trader from over leveraging their account and that something is the “5% risk at any one time” part of the rule. Otherwise, as you can see from the previous 5% per trade example, the trader with five trades with 5% account risk on each one would have 25% of their account at risk and the trader with ten trades would have had 50% of their account at risk. Clearly, neither of those would be a situation in which a prudent trader would want to find themselves

Learn more about the 5% rule and determine the appropriate leverage for your account:

How to Determine Appropriate Effective Leverage

Lesson 1 Money Management Video

--- Written by Richard Krivo, Trading Instructor

Money management rules for stock trading

Money management rules are an obvious part of every good stock trading strategy.

These rules should answer these questions:

• How big is my risk for one trade ?
• How many opened trades I can have at a time ?
• What is my risk:reward ratio ?
• and other important issues

These money management rules will help you to identify how many shares you can buy or sell short in a particular trade.

How big is my risk for one trade ?

The definition of maximal risk value for one trade could vary a little bit. Generally, the numbers used are between 0.5% to 2% of the total account size.

Example:
The account size is $100,000 USD. The maximum risk per trade is 1%. It means that you can risk $1000 USD on every trade. If distance between your entry and stop-loss level is $1 USD, then you know that you can open trade with 1000 shares. Simply calculated by (absolute risk)/ (point of distance between entry and stop-loss level).

Should you open trade with 1000 shares? No! You must check other money management rules and combine the results.

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My stock market trading tip:

If you are a beginner in trading, start with a small risk. Use 0.4% or 0.5% risk of the total account value. And as your confidence grows and your trading journal reports your success, increase it.

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How many opened trades I can have at a time ?

It isn’t easy to manage trades by moving stop or taking profits manually if you have a lot of trades and only two hands! You must be able to manage trades manually in case of any strong move on the stock markets. Even if your trades are not day trades but you are swing trading on stock markets, it can happen. So every trader must limit the maximum number of opened trades. The absolute maximum for a single person is eight open trades at once. Don’t surpass this hard limit.

Five or six open trades at once as a maximum is an appropriate limit for every trader.

Example:
Your swing stock trading account size is $100,000 USD. You decided to have max. five open trades at once. Your broker provides you with a 2:1 overnight margin. That means you can use $40,000 USD for one trade. How was it calculated? 100,000 x 2/5 = $40,000. So when you plan to buy XYZ stock with a stock price of $20 USD, this rule tells you that you can buy max. 2000 shares. Combine it with the number of shares from the previous rule and use the LOWER value for your trade setup.

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Special stock market trading tip:

During the first years of your trading set this number of trades to the lower value (like 3 or 4 max.)

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What is my risk: reward ratio ?

Never, ever try to have the risk reward ratio less then 2.5 to 1. This rule is crucial in your trading statistics, especially if you’re new to trading and without any relevant trade history, so set this ratio to 3:1.

Other relevant issues

There are also other important rules, which are part of a stock trading strategy.

Trade only liquid stocks. stocks have an average daily trading volumeover 300,000 shares traded per day (for swing trading stock) or above 1,000,000 shares per day (for online day trading).

Trade stocks with a price above $5 USD. Stocks with a low price aren’t traded by big institutional traders and therefore are easily manipulated. Technical analysis can fail on such stocks. Also, most big investment funds don’t invest in such low-priced stocks.

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Another of my tips on stock market trading:

All money management rules can be easily defined in spreadsheet (like Excel or OpenOffice Calc) and then all values are calculated automatically as you are entering your setup entry , stop-loss and targets .

Here is example of a spreadsheet table:

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http://www.simple-stock-trading.com/moneymanagement.html

Winning risk:reward Ratio

Risk/reward ratio is one the most influential parameters of any Forex system.

A good risk/reward ratio is able to make an unprofitable system profitable, while poor risk/reward ratio can turn a winning setup into a losing strategy.

Money management system #5 (Winning risk : reward ratio)

What is risk/reward ratio?

Risk - simply referred to the amount of assets being put at risk. In Forex it is the distance of our Stop loss level (in pips) multiplied by the number of lots traded. E.g. a stop loss at 50 pips with 2 lots traded would give us a total risk of 100 pips.

Reward - the amount of pips we look to gain in any particular trade - in other words the distance to a Take Profit level.

Example of risk/reward ratio:

100 pips stop vs 200 pips profit goal gives us 1:2 risk/reward.
25 pips stop vs 75 pips profit gives 1:3 risk/reward ratio.



Why consider risk/reward ratio at all?

An average trading system which is able to produce at least 50% of winning signals automatically becomes profitable if its stop and profit targets are set at 1:2 risk/reward ratio or higher.

On the other hand, a trading system which is capable of delivering over 70% of winning signals can still be unprofitable in the long run if it shows poor money management with, for example, 3:1 risk/reward ratio.



Small risk - large reward: a winning formula used by professional traders

How do they do it? Let's review some practical examples:

With low risk : high reward entries at the re-test of trend line, experienced trades can allow to be wrong multiple times before pulling out a winner, and still end up in profit.



Channeling, range bound markets also offer low risk : high reward trading opportunities. Besides, it is not only about getting in/out of a trade, but also about reviewing previous trends and positioning yourself in the direction of the most likely breakout, and in this way seeking additional profits plus once again eliminating the risk of stops being hit.



Wave traders like to ride market trends by entering on price retracement levels. These levels can be found using various studies and indicators: Fibonacci levels, support/resistance levels, trend lines, moving averages, which are treated as flexible trend lines, etc. All these studies help to see the points of retracement reversals.
When doing complex analysis of a retracement, special attention is paid to those price levels where two or more studies coincide in place and time with each other.



No matter what trading system you use, if you make sure your risk:reward ratio is set properly, you'll be trading on a profitable side, even when the number of your losing trades is greater than the number of winning trades.



http://forex-strategies-revealed.com/money-management-systems/risk-reward-ratio