The 1% risk per trade rule is one of the fundamental rules in trading.
Most professionals prescribe taking that percentage of risk for every trade since it's an optimum way to preserve trading capital.
But how can one appreciate this conservative setup, and how can it be put into actual practice?
This article will try to answer those questions and hopefully make sense of this cardinal rule in trading.
Why set a 1% risk?
When a 1% risk is in place, a trader virtually sets a limit to what his account can lose.
For example, an account with $10,000 can only lose $100 if a 1% risk is set.
And the idea behind it is to protect the trading capital from incurring a significant loss that would make a recovery an uphill battle.
Typically when a preset risk is absent, traders will have an arbitrary figure set as their risk.
But the problem in doing so is that it overlooks sound money management principles.
Establishing some degree of certitude
Since no one knows where the market is heading, it would be futile to try and predict it.
Investors have devised ways to forecast price throughout the years, but never achieved a level that's a hundred percent reliable.
Even a strategy built on technical indicators that showed a decent success rate in the past can lose its luster after some time, especially when the market conditions change.
The only thing that a trader has control over is risk management, which is why a trader must know how much is at stake initially.
When the dollar value is known beforehand, it will facilitate the evaluation of a viable trade setup.
The risk to reward ratio
And a viable setup is predicated by a favorable risk to reward ratio.
Moreover, determining the risk is the cornerstone for setting profit targets.
Obviously, a 1% risk would warrant a trader to seek higher returns, as that is the only way to attain profitability.
E.g., a strategy with a 40% win-rate can only become profitable if the profit target is greater than 1.5%.
A preset risk will also filter out trades that seem feasible based on a combination of technical factors but are unfavorable from a risk and reward standpoint.
Traders can assess the area on the chart where stop-losses can be placed and calculate the dollar amount that will be at risk.
At the same time, the potential profit targets are also visualized, which will then serve as a contrast for risk.
Thus a trade will only be taken if the likely reward is worthwhile relative to risk.
Here's an example: A trader gets a signal from his trading strategy to buy the EUR/USD at 1.2435.
The estimated risk is minus 50 pips, and the potential target is 100 pips.
Based on this, the trader has an excellent opportunity to enter a trade with a possible reward that's twice more than the risk.
Calculating a 1% risk
Now, the next step is to convert those 50 pips to 1% of the trader's account balance because, after all, the pips merely represent the difference in price from 1.2435 to 1.2385.
To get the 1% risk, calculation of the position size would be necessary.
For example, if the account balance is $20,000, then 1% would be $200.
That dollar value will be divided into the number of pips at risk, which in this case, is 50. So, $200 ÷ 50 pip = $4.
What that $4 represents is the per pip value, which factors in the lot size or the number of units of currencies.
And a pip value that's worth $4 equates to four mini lots.
Therefore, that is what a trader needs to use to limit losses to $200 but at the same time have the opportunity to make $400.
If the account drops to $19,800, then the subsequent 1% risk would be reduced to $198 and so on.
Prolonging the trading account
Essentially, what this 1% risk effectively does is that it extends the life of an account's balance in that it would take a long streak of losing trades instead of a massive one before getting a margin call.
In a sense, it would also give room for a trader to gain profits since the possibility of a sustained streak of losing trades is highly unlikely.
Calibrating to a lower or higher risk
Setting a risk per trade can also be calibrated according to the preference of the trader.
Some traders have a higher risk threshold whereby a 2% risk and a 4% target is more appealing, and the same can be said for traders who have a lower risk appetite and would prefer something less than 1%.
A remedy for emotional trading
Lastly, a major benefit of a predetermined risk is that it makes trading mechanical wherein expectations are properly managed.
And when traders know what to expect in case a trade goes south, it keeps them sane.
Plenty of traders lose their heads because they didn't preplan what their risk is going to be.
Did you know that there is a better way for you to improve your trading?