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Although some traders might disagree with it, legendary trader WD Gann himself persistently advocated risking 10% per trade due to his high strike rate of winning. He firmly believed that he would never experience 10 consecutive losses using his trading strategy. For him, this approach was effective.
Determining how much a trader should risk per trade is a crucial aspect of a trading money management system. The most commonly circulated myth online, endorsed by many professional traders, suggests risking only 2% or less per trade.
However, the question remains: will this strategy work for everyone? Let’s explore this in a detailed discussion from a statistical standpoint.
Imagine you’re a forex trader risking 2% with a $1000 account, aiming for a 4% profit (1:2 Risk-Reward ratio), with a 50:50 win-loss probability. Over 10 days, you could earn $1342.92 from three daily trades.
Now, if you maintain the same 1:2 risk-reward ratio but risk 10% per trade with a 30% win rate, your account balance would turn negative.
The reality is that most of us aren’t extraordinary. For many traders, risking 10% per trade can be considered overconfident and akin to gambling, particularly if they lack a solid understanding of the market. It’s important to note that WD Gann did not trade in the modern Forex market.
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Two Key Advantages of Risking 2%:
There are two significant factors that encourage traders to opt for lower risk levels.
1. Mental Peace & Reduced Trading Stress:
Risking 2% per trade offers a sense of mental peace and reduces trading-related stress.
2. Statistical Support:
With a 2% risk per trade, you have 100/2 = 50 attempts before depleting your entire account. This provides traders ample room to handle psychological drawdowns.
Drawdown Recovery Percentage Table
|% Loss of Capital||% Gain Required to Recover Loss|
Looking at the table above, if you risk 10% per trade and encounter five consecutive losses, your total loss would be 50%. This means you need a 100% gain to break even, which places immense pressure on you.
However, with a 2% risk per trade and five consecutive losses, you’d only lose 10% of your trading account. This means you’d only require an 11.11% return to reach the breakeven point. Clearly, this is less stressful in comparison.
Impact of Consecutive Losses:
Traders might claim that their strategy is foolproof and won’t result in five consecutive losses. Nevertheless, all strategies can fail under certain market conditions. When determining position sizing, it’s essential to consider the worst-case scenario. There will be days when you experience a win rate of 50% or even less.
Using the Excel calculator provided by Day Trading Life below, we can see that statistically, a 50% win rate has an 18.26% chance of experiencing five consecutive losses within a batch of 15 trades. As the number of trades increases, the likelihood of losses also rises. You can download the Excel spreadsheet using the link below to perform further calculations:
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Dependency on Risk/Reward Ratio:
In general, if your trading strategy employs a Risk/Reward ratio of 1:2, meaning you risk 2% to potentially gain 4%, you can achieve a 10% return on your account with a 50% win rate over 10 sample trades. With a higher win rate, you can earn even more while only risking 2% per trade. Refer to the example below:
The amount a trader risks per trade depends entirely on their own risk tolerance. Traders with smaller accounts often risk more than 2% per trade, driven by a desire to grow their accounts rapidly. This mindset can sometimes lead to significant losses, commonly referred to as “blowing the account.”
However, with disciplined trading, a trader can maintain a positive long-term trajectory for their trading account balance, as demonstrated in the first example.
Is it Possible to Lose the Entire Account Value Risking 2% per Trade?
With a 2% risk per trade, you generally have 50 attempts before losing your entire account value. It’s highly unlikely to experience 50 consecutive losses. Even if you were to trade with a coin-flipping approach, you’d still have a mix of wins and losses.
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Nevertheless, trading involves considering brokerage fees for each trade. Even with a 2% risk per trade and a 50% win rate, a downward trajectory can develop if your risk-reward ratio is less than 1:1. This means you’d lose more than you earn.
Additionally, overtrading is a pitfall to avoid. Continuously entering trades in the same price zone, trading during range-bound or volatile markets, and ignoring market conditions where technical analysis proves ineffective is not advisable. It’s crucial to recognize when the market is uncertain.
Once you steer clear of overtrading, resist prematurely taking profits, and allow losses to run longer, you’ll find that blowing accounts becomes a rare occurrence. This approach grants you the time to learn and ultimately succeed.
There isn’t a fixed rule for determining the appropriate risk level; it’s contingent on the trader’s risk appetite. If you’re comfortable with larger losses and greater risks, that’s acceptable. Remember, big risk can yield big profit, while small risk leads to smaller profit.
The pivotal factors are the trading system’s win rate and the maximum consecutive losses. If a trader typically experiences 5-8 consecutive losses, opting for lower risk is generally the wiser choice. Ultimately, the decision is grounded in mathematics and psychology.[wbcr_html_snippet]: PHP snippets error (not passed the snippet ID)