Even the best day traders out there can’t control the direction of the market. Ask any experienced day trader whether their next trade will be a winner or loser, and they’ll most likely say that they don’t have an answer to that question.
The only thing that traders can control is their risk. The 1% rule is all about efficiently managing risk to avoid painful losses and stay in the game in the long run.
In this article, I’ll explain the 1% rule, why is it so important to stick to it how to apply it in your daily day trading.
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What is the 1% Rule?
The 1% rule refers to the maximum amount of risk you’re allowed to take per any single trade. Traders who’ve studied risk management before will recognise this definition as risk-per-trade.
Under the 1% rule, you’re only allowed to risk up to 1% of your trading account per one trade.
This is achieved by adjusting your position size in such a way that when your stop-loss gets triggered, your total loss amounts to 1% of your trading account. We’ll cover position sizing later in this article.
While your total risk shouldn’t exceed 1% of your trading account under the 1% rule, it’s perfectly fine to risk a lower amount as well.
Whether you should risk less than 1% depends primarily on the size of your account. Traders who trade with higher amounts usually risk way less than 1% of their accounts, such as 0.5% for example.
Why Should You Use the 1% Rule?
The 1% rule is designed to avoid large losses on single trades, allowing you to stay in the game for a longer period of time. Imagine a trade that wipes out 50% of your trading account – it would take a return of 100% on all future trades only to get back to breakeven! That’s the main reason why so many beginners fail to become a consistently profitable trader.
Especially when traders are just getting started with trading, they tend to risk large sums of their capital on single trades.
One losing trade or a string of a few losing trades wipes out their entire account and they receive a margin call from their broker. With their self-esteem hurt, they either avoid funding a new account or make emotional trading decisions to return their lost funds. If they had followed the 1% rule and risked only a small portion of their account on any single trade, their loss would be tremendously lower.
There are three main rules to trading, coming exactly in the following order:
- Avoid losses
- Preserve your capital
- Make a profit.
We can’t control the outcome of our next trade or the market direction, but the only thing that is under our control is the amount of risk we’re taking.
Naturally, higher risk translates into a higher profit opportunity. However, as a trader, your goal is to control your risk and stay in the game in the long run. If you’re looking to double your account on each trade, you would be better off in a casino.
The following table shows how much profits you need to make after losing a part of your trading account.
|Amount of Balance Lost||Amount Necessary to Return to Initial Balance|
Losing 10% of your account requires a return of only 11% to get back to breakeven. However, a 75% loss requires a whopping return of 400% to get back to your initial balance! We’ll cover how to use the 1% rule to avoid those catastrophic losses in the following lines.
Read: Is Day Trading Gambling?
Reward-to-Risk Ratios and Risk-Per-Trade
Reward-to-risk ratios, also called R/R ratios, are an important concept to understand when using the risk-per-trade rule. Reward-to-risk refers to the ratio between the potential losses and the potential profits of a trade.
As you can see, reward-to-risk ratios are closely related to risk-per-trade, as they will define your potential profits on a trade. If you’re risking 1% of a $10.000 account, that equals to $100. This would be your total risk on any trade, i.e. if your stop-loss gets triggered, the total amount you would lose is $100.
If you define your preferred reward-to-risk ratio in your trading plan, you can easily calculate your potential profit for each trade. It’s recommended to use an R/R ratio of at least 2 or more, which means that you’re risking less than your potential profits.
By using a 2:1 R/R ratio and a 1% risk-per-trade on a $10.000 account, your potential loss on any single trade wouldn’t exceed $100, while your potential profit would be at least $200.
How to Use the 1% Rule?
To apply the 1% rule in your trading system, you have to understand how to calculate the correct position size for a trade. This is done by setting a stop-loss, calculating the dollar-value per pip and adjusting the position size accordingly.
First, let’s cover how to set your stop-loss levels.
Stop-losses are orders that close an open trade automatically after the price hits a pre-specified level. Stop-losses are used to limit losses in trading and play an important part in the 1% rule.
Don’t change the size of your stop-loss to reach a risk-per-trade of 1%!
Stop-losses should be placed based on your analysis and not on the maximum amount of money you want to risk. Position sizing is used to stay inside the 1% rule, not stop-losses.
There are four main types of stop-loss orders:
- Percentage stops – Percentage stops are based on a percentage of your trading account. For example, if a trader wants to risk 1% of his or her account on a trade, he could place a percentage stop at such a level that when the stop-loss gets triggered, his total loss doesn’t exceed 1%. Notice that this is not the correct way of using risk-per-trade. In the example above, our trader is using the stop-loss order to follow the 1% rule and not the position size.
- Volatility stops – Another popular type of stop-losses is volatility stops. Volatility stops are based on the volatility of the underlying instrument. The Average True Range is a popular indicator used with volatility stops. For example, a trader could place a stop-loss that is 1.5 times or 2 times higher than the ATR.
- Time stops – As their name suggests, time stops are stop-loss orders based on time. Time stops are usually combined with other types of stop-loss orders to avoid overnight risk or holding trades over the weekend.
- Chart stops – Finally, chart stops are stop-loss orders that are based on important technical levels. In my experience, chart stops return the best results among all the stop-loss types. Chart stops can be placed above important resistance levels or below important support levels, above/below trendlines, at Fibonacci levels, Pivot Points or any other technical tool.
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Once you determine your stop-loss size (preferably using chart stops), it’s time to move to position sizing. As said earlier, the size of your position will actually make sure that your risk-per-trade is met.
As a rule of thumb, a position size of 1 lot (100.000 units of the base currency) has a pip-value of $10. This means that our position size should be equal to 0.20 lots.
The same rules apply to stock trading as well. If you want to risk $100 per trade and place your stop-loss $2 away from the entry price, the maximum number of stocks you’re allowed to buy per the 1% rule would be 50.
1% Rule Trading Example
To make the 1% rule crystal clear, here comes another example. Let’s say the EUR/USD pair trades at 1.1050, and you want to enter with a long position after a breakout above a symmetrical triangle. With a $4.000 account, you know that your total risk per this trade shouldn’t exceed 1%, which equals to $40.
Using chart stops, you determine that the best place to put your stop-loss order would be just below the symmetrical triangle, which is around 40 pips away from the entry price. Now you have all data points required to calculate your position size.
Divide your risk-per-trade ($40) with your stop-loss in pips (40 pips) to get the dollar-value per pip. This step returns $1 per pip. Since one standard lot in the EUR/USD pair has a pip-value of $10, the maximum position size you’re allowed to open under the 1% rule would be 0.10 lots.
The 6% Rule – The Total Risk
If the 1% rule protects you from a single large loss, then the 6% rule protects you from a large number of small losses wiping out your account. The 6% rule refers to the maximum allowed risk per all open trades in your portfolio.
Let’s say you open two trades with a 1% risk-per-trade. While the maximum loss per any of those two trades would be 1% of your trading account, the combined risk is somewhat higher and equals 2% of your trading account. The 6% rule says that the total risk on all open positions shouldn’t exceed 6% of your trading account.
Under the 6% rule, you’re allowed to open six trades with a risk-per-trade of 1%, four trades with a risk-per-trade of 1.5%, three trades with a risk-per-trade of 2%, or any other combination as long as your total risk doesn’t exceed 6%.
The 6% rule protects you from large losses when the markets turn against you. Sometimes, our trading strategy simply stops working in the current market conditions, and the 6% rule allows us to stay in the game in the case of a series of losses and return to trading when market conditions improve.
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Risk management plays an important role in trading. Many beginners take too large bets on the market and blow their accounts in a matter of days. To avoid this from happening, use the 1% and 6% rules.
The 1% rule allows you to risk no more than 1% of your total account size. This helps you to dramatically limit losses on single trades and preserve your capital account.
The 6% rule combines the risk of all open trades in your portfolio and says that your total risk shouldn’t exceed 6% of your trading account. Both the 1% rule and 6% rule are extremely important in understanding and managing your trading risk and can have an enormous impact on your bottom line.