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.

Sounds good?

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.

That’s it!

For our next video we’ll look at how to place orders and enter trades.

Before making your first trade, you need to understand the mathematical logic behind trading.

This will allow you to balance risk versus reward.

Determine when to enter and exit a trade and ensure that you win in the long run.

In general, the profitability of your investment account depends on two factors: your hit rate and the risk to reward ratio of each trade.

Your hit rate is the percentage of winning trades, so if you make ten trades and win six, your hit rate is 60%.

Now, your hit rate doesn’t factor in how much money you made or lost in those trades, just whether or not you won.

If you trade using good setups and solid strategies, you should achieve a hit rate of about forty to sixty percent.

The next thing to look out for is the risk to reward ratio of a trade, otherwise known as the RR ratio.

This will help you achieve big wins, while keeping your losses low.

After all, like the famous financier George Soros once said, it’s not how often you’re right or wrong, but rather how much you make when you’re right and how much you lose when you’re wrong.

So if you only get it right 40 percent of the time, you want to make sure those trades make way more than all the losing trades.

The RR is calculated using three numbers. First, the EP or entry price: this is the price at which you enter the trade.

Next, the TP or target profit: this is the price you expect the stock to reach.

Finally, the SL or stop-loss: this is the price at which you will definitely get out of the position.

To calculate reward, you take the difference between the TP and the EP; while the risk is the difference between the EP and the SL.

The RR ratio is then calculated by taking the reward and dividing by the risk. Hence, the higher the reward, the better the RR, and the lower the risk, the better the RR.

Generally, you should be aiming for an RR of at least two to three, this means that your potential upside is two to three times your potential downside on some trades.

It might even be possible to get an RR of seven to ten.

Risk management is such an important part of trading and has such a huge impact on your profit and loss.

For instance, if you have a hit rate of only 40% but an RR of two, you’ll still end up profitable in the long run because remember, success isn’t about winning every trade, it’s about making those wins count.