I was reading my usual diet of blogs when I chanced upon OT's comments on this article, regarding Elder's rules in his sell and sell short book. It mentioned that there are two important rules to follow when trading:
1. Limit your loss on any trade to 2% of the equity in your trading account
2. Whenever the value of your account dips below 6% of the closing value at the end of last month, stop trading for the rest of the month.
The 2% / 6% rules are designed to prevent two kinds of ways that the market can kill you. I've written about piranha bites and shark bites before here, and the idea behind these two rules are based on these two ways too. The first way that the market can kill you is to kill you quickly and taking a big chunk of your capital in a single trade. That is why we have to limit the loss on any trade to 2% of your equity. I was reading the comments in OT's post and realised that there is a misconception regarding the 2% rule. The 2% rule is to limit your losses to 2% of your equity, and that is not the same as cutting loss if the shares drop 2% in price. What's the difference?
Before you begin a trade, you should have an idea of where you need to cut loss. Let's say you have $50,000 cash and you wanted to buy a stock priced at $1.00. Suppose that the cut loss for that stock is at $0.90. The potential loss is $0.10 (1.00 - 0.90). Since 2% of your equity of $50,000 is $1,000, you can at most lose $1,000 on any trade. We can thus calculate backwards to determine the position sizing of this particular trade in order to limit the loss to a maximum of $1,000. We'll take $1,000 divided by the potential loss of $0.10, and we get 10,000 shares, or 10 lots.
So take a look closely - if we buy 10 lots of the stock at $1.00 and if the price drops by 10% (0.1/1.00), the loss is just limited to $1,000, which is just 2% of our total equity. Thus the 2% rule is not a cut loss rule. By following strictly to the 2% rule, you'll prevent any one trade from wiping you out. In fact, you'll need 50 such trades before your whole capital is wiped out, if you un-wisely choose to enter 50 positions in one go.
To make it clearer, suppose that instead of buying the $1.00 stock with a cut loss of $0.90, you decided to make the cut loss level tighter at $0.95. The potential loss is now reduced to $0.05 but the absolute loss is still 2% of equity, which is $1,000. We can calculate the new position sizing for this particular trade - which works out to be 20 lots. You find that this rule allows you to vary the position sizing or the cut loss, but keeping the absolute amount of loss per trade at 2% of your equity. This means that if you're more confident of the trade, you can increase the position sizing but you have to tighten the cut loss. If you're not too confident of the trade, you can reduce your position sizing but you can also slacken your cut loss. The absolute amount is the only constant here.
The 2% rule can be implemented with sector allocation / diversification rules too. Suppose out of the $50,000, you only want 10% to be in this $1.00 stock. Having a cut loss level at $0.90 will allow you to have a position size of 10 lots of shares. However, having 10 lots of shares means that you have 20% of your equity in that position, which may be risky in terms of portfolio diversification. Since using the 2% rule allows me to have 10 lots, I'll reduce the position size to just 5 lots, so that I'm only 10% into this trade. When I reduce my position size, I have the liberty to slacken my cut loss level to $0.80, which would limit my loss for this trade to be $1,000 (2% of my equity of $50,000). Actually, I wouldn't even slacken my cut loss level, which is silly. But this is based on a maximum loss basis - meaning that you can lose up to $1,000 but not more than that. Again, I must also remind readers that the 2% rule does not mean that if the price drops by 2%, you'll cut loss.
After discussing at length about shark bites, there's still a problem about piranha bites, which is the second way that the market can kill you. If you keep limiting each trade's losses by 2%, you won't get killed by any particular trade but you might be wiped out if you made a string of small losses. So to prevent you from bleeding to death by a thousand small piranha bites (instead of a single shark but heavy shark bite), we have the 6% rule. The 6% rule is stop you from trading whenever you make too big a loss accumulated from many small losses. There is something obviously wrong if you keep making losses - either your method doesn't work in the present conditions or you're getting more emotional about your trades. Whatever it is, the 6% rule stops you from continuing to do silly things.
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