Never risk more than 2% of you trading account per trade. This is a perhaps the most common risk management rule and the one most violated.
Disciplined traders that use this simple risk management rule survive the inevitable draw downs that come to any trader whether they are using a mechanical trading system or a a totally discretionary system. The math behind the 2% rule is quite simple. To sum it up.. it is like reversed compounding. The deeper the hole you dig in consecutive losses the more you need to make back just to keep even and you will have to do this with less capital!
If you drawdown on a trade 25% of your account you will need to make a 33% return on your next string of trades just to get back to breakeven. A 50% drawdown means you now need a 100% return. A difficult task indeed.
The following chart is a quick example of how to use the 2% rule on a small $5000 account. You can adjust your trading accordingly.
The column on the right is the number of bad trades in a row a trader might sustain. If you are getting 10 trades in a row bad you should reconsider your system or career! But it can happen and you should understand your system well enough to know the maximum number of consecutive bad trades you are likely to have.
Using the 2% loss rule you should only allow about $100 of loss on that first trade using our $5,000 initial balance example. That would take your capital down to $4,900 and require a 2.04% upside to make it back to breakeven and you should only risk $98 loss on the next trade.
To put it in terms of futures trading, someone trading the ES mini with such a small dollar size should only be trading a single contract with a 2 point stop. If you do not have a system that allows you to get profits with such a tight stop than you either need to change your system until you build up enough capital to give you the stop headroom you need, add capital or find some other instrument to trade that fits into the this risk management rule.
The 2% rule should be a core value of any system you trade. Remember the goal is slow and steady. On you upside you will have compounding working for you also so as you build up your trading capital you can begin to increase your size and loosen your stops.
Safe Trading —
Marlin aka RedlionTrader