To be a trader, one fundamental topic that needs to be understood is risk management. Yes, the stock market is risky, but with proper risk management tools, you can limit the risk.
One risk management rule that I like (and use..) is the 2% rule. What this actually means is that on every trade, you are effectively risking only 2% of your total trading capital. Let me give you an example.
Assume you have $10,000 as your trading capital. 2% of that is $200. Have a look at the chart below. After analysing the charts, you have decided that there’s a line of support at (1) which is $19.06 and will place a stop loss (refer to my stop loss post) here. Assume the current price is $19.30 The difference is $0.24.
Remember again that you are only willing to risk $200 in this trade. You then decide to buy 833 shares (This is called position sizing. Will cover this later on). You bought 833 shares at price $19.30 and placed a stop loss at $19.06.
This means, if the trade goes wrong, you exit the market at $19.06 and you lose approximately $200 (excluding brokerage and financing costs).
Some people are more conservative and decide to risk only 1% of their capital at any given time. Aggressive traders might risk 3% or more. It all depends on the individual.
Personally, I try to risk only 2% on every trade.
Why this rule? Well, with the 2% rule, if you have $10,000 and you risk $200 on each trade, that means your trade needs to go wrong 50 times ($10,000 divide by $200) before your trading capital gets blown off. Hopefully, this won’t happen. Remember, to be a successful trader, SURVIVABILITY is key.