Clarifying the 5% Money Management Rule

One of the key components of Money Management is the 5% rule. That is, never put more than 5% of the trading account at risk at any one time. The rationale behind this is that when we have losses (and we WILL have losses, make no mistake about that) they will be small and manageable as opposed to large and catastrophic.

 

 

Oftentimes however, this rule is erroneously interpreted as meaning 5% per trade. This is not accurate.

 

The 5% rule pertains to the TOTAL amount of the account balance at risk at any one time…NOT on any individual trade. So, if you have one trade open, 5% is the maximum allowable risk. If you have two trades open or five trades open or ten trades open, the maximum that could be lost if the stops on all of the trades triggered at the same time is 5%.

 

Think of it this way, if the rule were 5% pertrade, a trader could open five trades risking 5% on each trade and still be within the rules. What would prevent a trader from opening up ten trades and only risking 5% on each one?

 

There has to be something that prevents the trader from over leveraging their account and that something is the “5% risk at any one time” part of the rule. Otherwise, as you can see from the previous 5% per trade example, the trader with five trades with 5% account risk on each one would have 25% of their account at risk and the trader with ten trades would have had 50% of their account at risk.

 

Clearly, neither of those would be a situation in which a prudent trader would want to find themselves.


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Posted By toyafields : 08 October, 2020
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