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The 2% Rule..!!

01 Aug
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There is a concept in risk management that you’ll here about, the 2% rule, although each person may have a slightly different set of standards. I think risk management is the most important thing for investors and traders to be up to speed on. Unfortunately, often traders are great with technical analysis or fundamental analysis and are totally lacking in risk management principles and discipline. You can be the best stock picker in the world and be knocked out of the game in 1 or 2 bad positions without risk management and discipline. So I present for your entertainment and hopefully financial well being, the 2% rule.

Basically what we have is a concept in which no one position should represent more than 2% risk to our entire portfolio should things go badly. This starts with planning and risk assessment before, not after the trade. All too often we are quick to say I like this stock here or there, but have no real plan for dealing with risk. When I look at a trade, a large portion of my time spent is identifying risk. I want to know at what point, if this trade goes against me, am I going to cry “uncle”. In other words, I’m identifying the risk associated with the trade. So don’t just look at the stock in terms of how much can I make, look at it in terms of how much can I lose. Once you have identified your risk, assuming the risk/reward ratio makes sense, you must quantify how much 2 % risk represents in your portfolio. Example: $10k portfolio x 2%risk=$200 risk. So now I know how much ($200) risk I can afford.

I now look at how much risk I have identified in the position. Example: buy xyz stock @ $11 with a stop(uncle point) @ $10=$1.00 risk. Now take $200.00 portfolio risk and divide it by $1.00 position risk and you come out with 200 if my calculations are correct ;) This means, so long as it doesn’t violate any other risk principles I apply, I can safely purchase 200 shares of XYZ @ $11 with a stop @ $10 and if my stop gets hit, my overall portfolio risk will be no more than 2%. This means I can afford to make a few mistakes in looking for that big winner.

There are sometimes things that may happen like gaps that’ll mess up the equation and expose you to more than 2% risk, but we can’t control everything, but everything we can control, we must. Taken the previous example (XYZ @ $11), obviously if we can buy closer to out stop ($10), we can afford to add more shares and thus increase our potential reward profile. Example: wait for a pullback in XYZ and buy @ 10.25 with the same stop @ 10=.25 risk—$200/.25=800 shares.

This has certainly changed our risk/reward ratio and has introduced another problem-do you want the majority of your portfolio tied up in 1 stock? I don’t and have my own rules for those situations; however it is clearly more profitable to buy closer to your stop thus decreasing your risk.

 

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