Managing Position Level Risk with Dr. Alexander Elder’s 2% Rule

Executing sound risk management principles in your trading is essential to having any chance of investment survival. If one position is sized too large and generates an enormous loss, this can be catastrophic to your account as well as your psychology as a trader. Fortunately, there are methods you can learn that will protect your account.

In The New Trading for a Living, Dr. Alexander Elder proposes a method for controlling risk at the position level which he calls the 2% Rule. This guideline states that the total risk in any position cannot exceed 2% of the current month-end account value. For example, if you have $100,000 in your account at the end of the previous month, the 2% Rule limits your maximum risk on any trade to $2,000. That is, risk is defined as the dollar value of the difference between your purchase price and stop loss and cannot exceed 2% of the account value under this rule. Be sure to not confuse 2% with the total position size.

While 2% may seem small, Elder notes that most professional traders risk even less than 2% or closer to 1% per position. He adds, “Good traders tend to stay well below the 2% limit. Try to risk less than 2% - it is simply the maximum level.” Heed this advice and your risk management will provide you with a chance at trading success.

"Keeping your risk small and constant is absolutely critical" - Larry Hite 

In the world of professional trading, risk management is the most important element when designing a profitable trading strategy. Keeping risk per trade manageable can be accomplished by understanding the probabilities of your system. For example, knowing the probable number of losses in a row, winning percentage, and average gain to average loss of your system will help you minimize over-exposing your account to the market at inopportune times. Additionally, risk per position is determined by your proprietary position sizing algorithm and finding the optimal position size is based on your system’s past performance.

Furthermore, the 2% Rule links the size of your trades to your performance as well as account size. For example, if your hypothetical $100,000 account earned 5% last month then you would be able to risk $2,100 per trade going forward. That is, 2% of total account equity, $105,000, now equals $2,100. Conversely, if your account declines by 5% your total equity is now $95,000, you will only be able to risk $1,900 per trade idea. In effect, the 2% Rule will enable you to trade more when your system is in favor and less when it is out of sync with the market, thereby offering performance-based risk management.

An additional benefit to the 2% Rule can be found through helping traders learn to pyramid into a position. That is, traders may layer risk in a position through 50 basis point (bps) increments* ultimately topping out at 200bps or 2%. Leveraging up into a full position is a skill shared by all professional traders.

Begin adhering to the 2% Rule and you will be taking the right steps toward replicating professional money management. Keep your position sizes manageable for the well-being of your account and your emotions. Ultimately, the 2% Rule will enhance your chances of making trading profitable.

In a follow up post I will be discussing how Dr. Elder suggests traders manage risk at the portfolio level.

As always, please feel free to contact me with any comments or questions. Thanks for reading.

John

*Referred to as an inverted pyramid when compounding a position. This provides maximum leverage. (Trading Systems and Methods, Perry Kaufman)