- What does the 1% to 3% rule mean exactly?
- What is the logic behind the rule?
- How much should you risk optimally?
- Do you risk more than the thumb rule?
What does the 1% to 3% rule mean exactly?
So if you’ve read my blog posts or even watched videos I’ve posted on YouTube regarding risk management, then you might be knowing what the 1% to 3% rule is exactly.
If you don’t, it’s fine. So the rule actually means that you should not be risking more than 1% to 3% of your trading capital, on any given trade that you take.
What does this mean? We’ll take an example. Say that you are a trader trading with a capital of $100,000 and you see a trade opportunity.
Now, you will be taking some risk right when you enter the trade, how much risk will that be exactly? Yes, 1% to 3% maximum.
So, in the trade, or any other trade that you’ll take, you won’t risk more than $1,000 to $3,000, that’s 1% to 3% of $100,000.
Say that you see a trade opportunity on EURUSD, you see where you’ll enter and where you’ll place stop loss.
Now, you just need to decide your position size and that’ll be easy for you as you already know how much you’d be risking in the trade and you just need to divide that amount with the stop loss.
Whatever capital that you trade with, you need to know exactly how much 1% to 3% will be, it should be at the back of your head, not literally though.
What is the logic behind the rule?
No one likes a loss and you know what, there’s research that proved that we are likely to react 5 times more to a loss than we’d react to profits we make, and this tells us so much about human psychology.
So what this research actually concluded was that when we have a winning trade and even a losing trade, it triggers a part of our brain, and that makes us feel 5 times worse when we have a losing trade as compared to the happiness we would have with a winning trade.
This is one of the most important and the most underrated reasons for having a risk management rule in the first place.
In the beginning, I said that risk management won’t just protect your capital, but will also protect you, and this is how it would.
Say that you risked more than 3% on a trade, let’s consider that you risked 5%, now, if the trade goes south and loses money, this loss is going to affect you in many ways.
You would either end up going after the market for payback by revenge trading, or you’d take random trades just to recoup losses, but end up digging an even deeper pit for yourself to fall into.
It’s all a domino effect that all starts from one small thing, poor risk management.
This was the more psychological logic for the risk management rule, and now I’ll tell you the obvious reason for the rule, to protect your capital.
Now, you need to have good risk management because, strategies aren’t going to win always, and we have limited capital to trade with.
There’s even this strategy known as the Martingale strategy, where after every loss, the trader would double in the next trade, and statistically, this strategy works, but realistically, it’s a fail because we do not have access to unlimited capital to trade with.
Now, let’s say that you trade with a strategy, risk 5% per trade, and had 10 losing trades back to back. You are now down 50% of your capital and that is a big hit to take.
Say that you went from $100,000 to $50,000 and now, to get your capital back to break even, you’ll have to double the $50,000, which is not an easy thing to do.
On the other hand, if you risked only 2% and had the 10 trades losing streak, then yes, you’d be down 20%, but you’d be down to $80,000 and to get back to break even, you need to make only 25% and that’s still doable as compared to a 50% gain.
Just see how a losing streak coupled with poor risk management can put a dent in your capital and also, your psychology.
That’s why, risk management is the only holy grail in trading, and you shouldn’t be risking more than 1% to 3% in any given trade.
But, now you might ask, why exactly 1% to 3%, and now I’ll tell you the reason behind it.
How much should you risk optimally?
You know first I used to think that the 1% to 3% thumb rule, was more like a random figure but then I sat down one day and I tried to get to the roots and I did come to a conclusion.
So I tested things and I came to a conclusion that if we risk just 1% on any given trade, then we would easily manage to take 73 trades and we’d still have our capital.
So, if you want to survive for at least 73 trades, then risk just 1% in any given trade.
But this thumb rule of 1% to 3% is more subjective than objective and it depends on you and your risk tolerance.
If you like to take higher risks but still want to stay within the risk management thumb rule, then go for 3% risk per trade or less.
If you are very risk averse then anything below 2% would be great for you and keep you sleeping soundly at night.
Now, whatever percentage you risk per trade, make sure that it is optimal for you, and by optimal, I mean that it shouldn’t be higher than what you can take, that it messes up with your psychology in case of a loss.
There was research that was conducted and it concluded that a trader’s risk management rules directly affected their trading performance in the end.
So make sure that you stay well within the thumb rule and you’ll be good to go.
Do you risk more than the thumb rule?
Are you one of those traders that risk more than 3% on any given trade? How has that turned out for you? I’d like to know.
Also, if you’re one of those risk averse traders that like to have a good sleep at night than to have their trades keep them up all night, how has that turned out for you too?
Share this blog post with every trader that you know and let them also understand the importance of risk management and the reason for the 1% to 3% risk management thumb rule in trading.
Feel free to ask me any question in the comments section below and I’ll get to it as soon as I can.