The 1% rule is a risk management guideline followed by many day traders. It recommends that traders risk no more than 1% of their trading account on any single trade. This helps control losses and ensures traders have enough capital to continue trading through losing streaks.
What is the 1% rule?
The 1% rule states that a day trader should risk no more than 1% of their account on a single trade. For example, if a trading account contains $10,000, then the most a trader should risk per trade is 1% of $10,000, or $100.
This means a stop loss should be placed so the maximum loss on the trade is $100 or less. If trading a stock priced at $10 per share, this would equate to a maximum risk of 10 shares per trade (10 shares x $10 per share = $100 maximum loss).
Why follow the 1% rule?
There are several key benefits to following the 1% rule:
It limits losses
By capping the amount risked at 1% of the account, losses are limited on any single trade. This prevents traders from losing too much capital on one bad trade. Even 10 losing trades in a row would only amount to a 10% loss if the 1% rule was followed each time.
It controls position size
The 1% rule forces traders to trade small position sizes in relation to their account size. This helps prevent overtrading and overleveraging, which are common causes of blowing up trading accounts.
It allows for greater staying power
Limiting the risk on each trade to 1% of capital allows traders to withstand a string of losing trades. By preserving trading capital, traders are able to stay in the game long enough to potentially capitalize when their system becomes profitable again.
How is the 1% rule calculated?
Here are the steps to determine proper position sizing using the 1% rule:
- Calculate 1% of total trading capital
- Estimate the distance from entry to stop loss
- Determine position size where risk = 1% of trading capital
For example:
- Trading account size: $10,000
- 1% of $10,000 = $100
- Planned entry: $25
- Planned stop loss: $24
- Distance from entry to stop loss: $1
- To risk $100, take a position size of 100 shares ($1 risk per share)
Does the 1% rule work for small accounts?
The 1% rule can be challenging to follow for smaller accounts. 1% of a $2,000 account is only $20, which significantly limits position size and earning potential per trade.
Some adjustments traders make when applying the 1% rule to small accounts include:
Trade wider range stocks
Wider range stocks allow for larger position sizes. For example, if trading a stock between $20 and $25, the 1% stop loss could be placed $1 below entry allowing for a larger number of shares.
Use futures or forex
These markets offer greater leverage, allowing smaller accounts to take larger positions while still limiting risk to 1% of capital.
Start with less than 1%
Some traders are more comfortable risking 0.5% to 0.75% of the account per trade when first starting out. This still applies the theory behind the 1% rule without being overly restrictive on trade size.
What are the downsides of the 1% rule?
While the 1% rule is good general guidance, there are some potential downsides traders should be aware of including:
Opportunity cost
Capping risk at 1% may cause some winning trades to be exited too early. Traders could miss out on large gains when forced to follow the 1% rule.
Changes required as account grows
As the trading account increases in size, position size has to be continually adjusted to stay within 1% limits. This can require frequent recalculation.
Doesn’t account for volatility
A volatile stock will have larger price swings, requiring a wider stop loss and smaller position size compared to a less volatile stock if adhering strictly to the 1% rule.
Do professional traders follow the 1% rule?
The 1% rule is often cited as an ideal beginners’ guideline, but do professional traders follow it? The reality is it varies case by case. Many professionals do adhere to the general theory of limiting risk, but may be more flexible or customized in how its implemented.
Here are some ways professional traders may diverge from the strict 1% rule:
Risk less than 1%
Some professionals scale risk down to 0.5% or 0.25% per trade, especially when trading larger accounts. This helps further limit drawdowns.
Risk more than 1%
Very aggressive traders may be comfortable with 2% or more risk per trade. This requires high confidence in their strategy and ability to manage larger losses.
Base risk on volatility
Instead of a fixed 1% per trade, risk may be adjusted based on the actual volatility and price movement of the instrument traded.
Alter risk by strategy
A trader may risk less on speculative trades and more on higher confidence setups. The 1% rule can be adjusted by strategy.
So in summary, many professionals use the 1% rule as a starting point but ultimately tailor risk based on personal preferences and trading style.
Tips for following the 1% rule
Here are some tips for effectively implementing the 1% rule in your own trading:
Accurately calculate trading capital
Only factor in what is readily available for trading. Do not include other assets, retirement funds, real estate value, etc.
Define and stick to stop losses
Determine stop levels before entering trades and stick to them consistently. Move stops to lock in profits where possible.
Trade smaller share sizes
Err on the side of smaller position sizes if unsure. Losses are easier to recover from when positions are not too large.
Use stop limit orders
Stop limit orders can help control slippage and prevent losing more than 1% from fast moving markets.
Review and adjust regularly
Reevaluate position sizes and stop levels frequently as account size grows or market volatility changes.
Using the 1% rule in different markets
While originally focused on stocks, the 1% rule can be applied to other markets as well:
Forex
Many forex traders alter the 1% rule to be 1% of account per position, not 1% per trade. For example, they may enter a long USD/JPY position and a short EUR/USD position simultaneously, putting 2% of the account at risk.
Futures
Like forex, the greater leverage in futures allows the dollar amount at risk per contract to be controlled. Stop losses would be set to contain losses to 1% of capital given the number of contracts being traded.
Options
Options traders can calculate 1% of capital based on the max loss if the traded options expire worthless. Risk can be defined as premium paid per position size.
Cryptocurrency
Crypto traders may need to adjust stops more frequently as the dollar value and volatility of coins change rapidly. The 1% rule can still be implemented based on updated account and coin values.
The 1% rule vs the 2% rule
Some traders follow a 2% rule instead of the 1% rule. What is the difference?
1% rule
- Risk per trade capped at 1% of account
- Less aggressive approach
- Lower potential profits per trade
- Requires longer winning streaks
2% rule
- Risk per trade capped at 2% of account
- More aggressive approach
- Higher potential profits per trade
- Increased chance of larger losses
Ultimately there is no definitively “correct” percentage. Traders should consider factors like account size, risk tolerance, and trading strategy when choosing between a 1% rule vs 2% rule for risk management.
Conclusion
The 1% rule is a straightforward risk management technique that can help beginner traders protect their capital while gaining experience. However, it does require discipline to follow in real trading.
While losses are capped at 1% per trade, traders must avoid revenge trading or overleveraging in hopes of recovering those small losses quickly. Patience and sticking to the plan is key.
As a trader becomes more experienced, they may modify the 1% rule or utilize more advanced risk management methods. However, the basic concept of limiting risk on a per trade basis can benefit traders at all levels. Proper risk management is a cornerstone of longevity and success in trading.