We all know that the goal of trading is to make money and so far we’ve learned that as long as you have an edge in the market you will be profitable in the long run.
So the next question is how do you maximize your profitability without blowing up your account?
The answer lies in the 2% money management rule.
This rule states that you should never commit more than 2% of your available capital on a single trade.
Let’s say you have $10,000 to bet and you’re considering a particular trade with a hit rate of 60%.
How much should you bet?
If you bet the whole $10,000, you have a 60% chance of doubling your money
But you also have a 40% chance of losing everything.
That’s pretty exciting if you’re a gambler but not ideal if you want to remain profitable in the long run.
Let’s say you split your $10,000 into two bets of $5,000 each your probability of losing two bets in a row is only 16 percent or 40% x 40% which means your chances of losing everything are much less.
Well if you took it one step further and split your $10,000 into ten bets of $1,000 each, your odds of losing everything would drop to just 0.01%.
However, the amount you’re betting each time would still be pretty high.
10% of your total capital.
That means if one of your trades goes sour, you lose 10% of your money.
If you stuck with the 2% rule you’d only bet $200 per trade.
Not only does this put a firm manageable cap on how much money you can lose for each trade, it virtually eliminates your chance of losing everything If you remember from our previous video, the risk of a trade is calculated by taking the difference between the entry price and stop-loss price and multiplying by the quantity traded meaning with the 2% money management rule, the only way to lose all your trading capital is to lose 50 times in a row, and the probability of that happening is less than 1 quintillion percent.
Now those are sound odds!
After all, as a money manager, your focus shouldn’t be on making the most money; that’s what a gambler does.
Your focus should be on ensuring that you do not lose your capital.
It’s like Warren Buffett once said the number-one rule is to not lose money and while there will always be stories of traders blowing up their account, if you stick to the 2% money management rule, it is virtually impossible for you to do the same and not only that, it’ll also help you improve your trading results across the board.
For our next video we’ll look at how to place orders and enter trades.