The New Sell and Sell Short: How to Take Profits, Cut Losses, and Benefit from Price Declines, Expanded Second Edition

RISK CONTROL

If trading is a high-wire act, then risk control means putting on a safety harness. It will save your life in case you slip.

Overtrading means putting on trades whose size is too large for your account. When the stakes become dangerously high, we become stiff with tension, spontaneity goes out the window, and our performance deteriorates. Sensible risk control keeps the size of your trades at a fairly relaxed level.

The two pillars of money management are the 2% and 6% Rules.³ They will help save your account from the two main causes of trader mortality: the 2% Rule from shark bites and the 6% Rule from piranha bites.

A shark bite is a single disastrous loss that severely damages one’s account. A poor beginner who loses one-third of his equity would have to generate a 50% return on his remaining capital simply to break even. The victim of a shark attack loses much more than money: he loses confidence, becomes fearful, and cannot pull the trigger. We can avoid this problem by following the 2% Rule which keeps any loss to a small, livable size.

The 2% Rule prohibits you from risking more than 2% of your account equity on any single trade.

Suppose you have $100,000 in your account—the 2% Rule tells you that your maximum permitted risk on any trade is $2,000. You decide to buy a stock that is selling for $40 and put a stop at $38, risking $2 per share. Dividing your total permitted risk by your risk per share ($2,000 by $2) tells you that you may trade a maximum ...