PDA

View Full Version : The 2% Rule--Alex Elder



airedale
07-11-2005, 12:12 PM
I get Alex Elder's emails. The last one went over the 2% rule. I do use the 2% rule, but occasionally it gets a stretched a bit.
This will help to re- focus my attention. May help others,too.


----- Original Message -----
From: Financial Trading Seminars, Inc.
To: Elder Books and Trades
Sent: Saturday, November 05, 2005 8:28 AM
Subject: elder.com Books & Trades #130 - Risk Control … Webinar … Classes


Books & Trades #130

November 4, 2005

Dr. Alexander Elder
www.elder.com



RISK CONTROL

In recent weeks I’ve been talking to a friend who hit a wall in his trading and lost a lot of money this year. When I found out about his losses, I asked to see the records for one of his accounts. Two causes of his bad losing streak jumped at me from the spreadsheet he sent. First of all, he kept violating the 2% and the 6% money management rules. Second, he was very lax using stops, and I saw stocks in his account that he bought for 88 trading down at 49 and worse. Let us review his mistakes.

The 2% Rule forces you to limit your risk on any given trade to 2% of your account equity. Of course those of us who trade larger accounts tend risk a lot less than 2%, but this Rule sets the absolute maximum risk level.

For example, if you are trading a $200,000 account, you cannot risk more than $4,000 on any trade. Suppose you buy a stock at $30 and put a stop at $26 – your risk is $4 per share. Now you have to divide your total permitted risk, which is $4,000, by your risk per share, which is $4. $4,000 divided by $4 comes to 1,000 shares – the 2% Rule dictates your maximum position size. In practice, the number should be even lower to cover commissions and possible slippage.

The 6% Rule limits your maximum loss per month to 6% of your account equity. Taking that $200,000 account, if your equity dips to $188,000, you are forced to stop trading for the rest of the month and spend the remaining time re-examining your performance.

The 2% and 6% Rules put a dual safety net under your account. A person who does not have enough discipline to follow these rules is doomed in the markets. Violating these rules is like driving on the wrong side of the road. No matter how good a driver you think you are, one of these days you will have a face-to-face encounter with a cement truck, which is what happened to my friend.

Following the 2% and 6% Rules is a straightforward discipline issue – if you do not have it, you do not belong in the markets. Or perhaps you do – to provide winnings for those of us who follow the rules.

The second major issue in my friend’s drama was not using stops. There are two main types of stops – I call them hard stops and soft stops. A hard stop is an order given to your broker – after buying that stock for $30 place a stop order to sell automatically if it dips to $26. Many professionals do not like using hard stops and prefer soft stops – they have a level in mind at which to bang out of their trade. A soft stop gives them the latitude to cut and run a little sooner or a little later, using their professional judgment.

A beginner trader has no choice but to use hard stops unless he wants to become shark food. Soft stops are very appealing because they give you more freedom. You can earn the right to use them only by proving that you have iron discipline and good judgment. You prove it by having at least one full year of successful trading with hard stops. The appeal of soft stops is that they sometimes allow you to sidestep whipsaws; the danger is that they allow you to delude yourself that your stock is about to reverse while it keeps going against you. My friend who lost all that money is a big fan of soft stops.

I felt very sad looking at his spreadsheet – is another good man going down the drain? After reviewing his records, I explained it was a life-or-death situation for him in terms of trading. To recover he must religiously observe the 2% and 6% Rules, as well as use only hard stops for the next year.

Money management and record

robbo
21-11-2005, 10:14 PM
[quote]quote:Originally posted by airedale

I get Alex Elder's emails. The last one went over the 2% rule. I do use the 2% rule, but occasionally it gets a stretched a bit.
This will help to re- focus my attention. May help others,too.


----- Original Message -----
From: Financial Trading Seminars, Inc.
To: Elder Books and Trades
Sent: Saturday, November 05, 2005 8:28 AM
Subject: elder.com Books & Trades #130 - Risk Control … Webinar … Classes


Books & Trades #130

November 4, 2005

Dr. Alexander Elder
www.elder.com



RISK CONTROL

In recent weeks I’ve been talking to a friend who hit a wall in his trading and lost a lot of money this year. When I found out about his losses, I asked to see the records for one of his accounts. Two causes of his bad losing streak jumped at me from the spreadsheet he sent. First of all, he kept violating the 2% and the 6% money management rules. Second, he was very lax using stops, and I saw stocks in his account that he bought for 88 trading down at 49 and worse. Let us review his mistakes.

The 2% Rule forces you to limit your risk on any given trade to 2% of your account equity. Of course those of us who trade larger accounts tend risk a lot less than 2%, but this Rule sets the absolute maximum risk level.

For example, if you are trading a $200,000 account, you cannot risk more than $4,000 on any trade. Suppose you buy a stock at $30 and put a stop at $26 – your risk is $4 per share. Now you have to divide your total permitted risk, which is $4,000, by your risk per share, which is $4. $4,000 divided by $4 comes to 1,000 shares – the 2% Rule dictates your maximum position size. In practice, the number should be even lower to cover commissions and possible slippage.

The 6% Rule limits your maximum loss per month to 6% of your account equity. Taking that $200,000 account, if your equity dips to $188,000, you are forced to stop trading for the rest of the month and spend the remaining time re-examining your performance.

The 2% and 6% Rules put a dual safety net under your account. A person who does not have enough discipline to follow these rules is doomed in the markets. Violating these rules is like driving on the wrong side of the road. No matter how good a driver you think you are, one of these days you will have a face-to-face encounter with a cement truck, which is what happened to my friend.

Following the 2% and 6% Rules is a straightforward discipline issue – if you do not have it, you do not belong in the markets. Or perhaps you do – to provide winnings for those of us who follow the rules.

The second major issue in my friend’s drama was not using stops. There are two main types of stops – I call them hard stops and soft stops. A hard stop is an order given to your broker – after buying that stock for $30 place a stop order to sell automatically if it dips to $26. Many professionals do not like using hard stops and prefer soft stops – they have a level in mind at which to bang out of their trade. A soft stop gives them the latitude to cut and run a little sooner or a little later, using their professional judgment.

A beginner trader has no choice but to use hard stops unless he wants to become shark food. Soft stops are very appealing because they give you more freedom. You can earn the right to use them only by proving that you have iron discipline and good judgment. You prove it by having at least one full year of successful trading with hard stops. The appeal of soft stops is that they sometimes allow you to sidestep whipsaws; the danger is that they allow you to delude yourself that your stock is about to reverse while it keeps going against you. My friend who lost all that money is a big fan of soft stops.

I felt very sad looking at his spreadsheet – is another good man going down the drain? After reviewing his records, I explained it was a life-or-death situation for hi

airedale
27-11-2005, 10:39 PM
Hi Robbo, whatever, works for you is best for you. But if your 2nd golden rule is :Do not lose money: and then one of your positions slips 50%. That is a loss of trading capital which you are hoping to recover with a 100% gain.
Then if you commit 15% of your capital to one share which then goes down 40%, you could be sidelined for a long time waiting for a recovery. Unless you have very deep pockets,of course.
Why not cut your losses early and buy back in again when it starts to go up.
Cheers, and good trading,

Mick100
28-11-2005, 06:12 PM
I buy shares with the intention of holding for five yrs plus so being 20-30% down on a share is no problem for me. When I research a company I always make assumptions regarding the future prospects of the company. If these assumptions turn out to be wrong then I will sell that share at a loss or, very occasionally, at a profit.
So wheather you follow a 2% rule, a 10% rule or a 50% rule (mines 50%) depends on the timeframe that you are looking at. If you are trading you should have some strict criteria to limiit losses but if you are investing for the long term it's not so critical to limit paper losses.
.

duncan macgregor
30-12-2005, 06:20 PM
[quote]Originally posted by Mick100


I buy shares with the intention of holding for five yrs plus so being 20-30% down on a share is no problem for me. When I research a company I always make assumptions regarding the future prospects of the company. If these assumptions turn out to be wrong then I will sell that share at a loss or, very occasionally, at a profit.
So wheather you follow a 2% rule, a 10% rule or a 50% rule (mines 50%) depends on the timeframe that you are looking at. If you are trading you should have some strict criteria to limiit losses but if you are investing for the long term it's not so critical to limit paper losses.
MICK100 I buy shares with the intention of not losing money.
Since i am not hands on in any of the companies that i invest in i know that i will be told all sorts of lies etc regardless of my scrutinizing the records. It is in my opinion imperative to have my escape route planned in advance. I really dont care how long i hold as long as its in an uptrend. That is the most important thing in my system after the buy is knowing when to sell. macdunk

Mick100
30-12-2005, 08:03 PM
As I said in my post Macdunk if your trading then you should have a mechanism in place to get you out of losing trades smartly, as you do with your stop losses.

I can give you an example of how I operate
About the middle of this yr I bought shares in NEO (a junior oiler drilling for gas in the US)
I had been following this company for 6 months before i bought shares in it
They were having good success with their drilling programe having found gas in at least three of the holes and also oil freeely flowing out of another hole. Then they made an anoucment that they would be building a gas line to connect to the main gas line nearby (this is the point where I jumped in) The gas line was to be connected in sept- oct sometime this yr

oct came and went - no connection
It was delayed a couple of months
Then in Dec it was delayed until feb 2006
(this is when I sold my shares)

I bought the shares assuming that they were going to be selling gas in sept-oct, which didn't happen so I sold my shares at a small loss.

I watch managment very closely
If I'm not comfortable with the managment style I'm usually out of that company within 6 months of buying them
I could go as far as to say that when I buy shares in a new company I put that company on probation for the first 6 months.
,

Dough Boy
16-01-2006, 02:44 PM
I am a long-term investor so don't bother with stop losses and such like as my strategy is simply to buy on value / quality and be quite happy to see a share drop from initial purchase price as I can then buy more at discount.

Share price only matters for how much I paid for a company and how much I sold it for when I have close-out my position. The share price fluturation in the intervening period do not matter, rather the company's performance is a far more important issue to be followed.