By risking 1% of your account on a single trade, you can make a trade which gives you a 2% return on your account, even though the market only moved a fraction of a percent. Similarly, you can risk 1% of your account even if the price typically moves 5% or 0.5%. You can achieve this by using targets and stop-loss orders.
You can use the rule to day trade stocks or other markets such as futures or forex. Suppose you want to buy a stock at $15, and you have a $30,000 account. You look at the chart and see the price recently put in a short-term swing low at $14.90.
You place a stop-loss order at $14.89, one cent below the recent low price. Once you have identified your stop-loss location, you can calculate how many shares to buy while risking no more than 1% of your account.
Your account risk equates to 1% of $30,000, or $300. Your trade risk equals $0.11, calculated as the difference between your stock buy price and stop loss price.
Divide your account risk by your trade risk to get the proper position size: $300 / $0.11 = 2,727 shares. Round this down to 2,700, and this shows how many shares you can buy in this trade without exposing yourself to losses of more than 1% of your account. Note that 2,700 shares at $15 cost $40,500, which exceeds the value of your $30,000 account balance. Therefore, you need leverage of at least 2:1 to make this trade.
If the stock price hits your stop-loss, you will lose about 1% of your capital or close to $300 in this case. But if the price moves higher and you sell your shares at $15.22, you make almost 2% on your money, or close to $600 (fewer commissions). This is because your position is calibrated to make or lose almost 1% for each $0.11 the price moves. If you exit at $15.33, you make almost 3% on the trade, even though the price only moved about 2%.
This method allows you to adapt trades to all types of market conditions, whether volatile or sedate and still make money. The method also applies to all markets. Before trading, you should be aware of slippage where you’re unable to get out at the stop loss price and could take a bigger loss than expected.