Carefully consider how much trading capital to dedicate to each trade and how it impacts your overall portfolio. It might seem okay to lose 3% on a single trade, but what if that amount represents 3% of your entire trading account balance?
To reduce large losses on a single trade, you may want to consider the “1% Rule.” The idea behind the rule is straightforward: prior to entering the trade, determine how much you’re willing to lose if the trade goes against you. Then, build your trade in a way that limits your per-share risk to that amount.
Taking the 1% Rule literally, you would try to limit your risk on any single trade to 1% of your trading dollars. The appropriate percentage or dollar amount you are willing to risk on each trade will be based on your own objectives and strategy.
The 1% Rule
Let’s say you have a total of $78,500 of trading capital in your trading portfolio. If you’re following the 1% Rule, you won’t risk more than 1% of that $78,500 portfolio on any single trade. Multiplying $78,500 by 1% results in your total calculated risk for a single trade being $785.
Based on the calculated risk per trade, you can now determine your risk per share. This will help you calculate the number of shares you can buy without losing more than 1% from your trading account.
Calculating the number of shares
Your maximum risk amount per trade is $785. Let’s assume you want to enter a trade for XYZ at $30 and, from your trade analysis, will exit the trade if the price falls to $29. This exit point represents the loss you’re willing to accept on the position, or $1 per share. To calculate the number of shares you’ll purchase, divide the maximum loss of $785 by the per-share loss of $1; this equals 785 shares.
When calculating the maximum number of shares to buy, be sure to round down any fractional shares so you don’t exceed your risk amount. For example, if the result had been 785.6 shares, you would round down to 785 shares, NOT up to 786 shares.
Putting the position sizing plan into action
Now that you’ve established a maximum per-share loss of a $1.00, and that 785 shares will help to limit a potential trade losses beyond $785, the final step is to incorporate this information into your trade.
You’ll then want to determine a stop-loss exit that will help control your maximum risk per share. Calculate the risk per share by subtracting your target purchase price of $30 from your per share risk amount of $1. This results in a stock price of $29 and is the price at which you will set a stop order to help limit the potential downside of this hypothetical trade.
While your analysis shows that you expect the stop price to go up and you have a target exit price on, you’ve now also considered and planned for the possibility of the stock going down instead of up. Placing a stop- order at $29 will trigger a market order if the stock goes at or below your $29 stop-loss price, helping you exit the position. This helps you manage your risk by keeping your loss within the $785 acceptable range, preserving your trading capital for other trades
There is one important thing to note about the stop order type. A stop order becomes a market order to sell when a trade occurs at or below the established price. In a fast-moving market, or in the case of stocks that have light trading volume, it is possible for a stop order to fill at a price that is not close to the price that triggered the stop. In our example, your stop-loss order of $29 could get filled at a price lower than $29, which would make your maximum loss greater than $785.
Thinking through your maximum loss on any trade is a prudent risk-management tactic. Use the 1% Rule or similar approaches to help you figure out the number of shares to buy based on the maximum per-share loss that you’re willing to take. Consider using a stop order when placing your trade, but be sure to recognize the limits of a stop order.
It’s important to note that the 1% Rule could be the 2% Rule, the 3% Rule, or whatever percentage that fits your trade strategy. The more tolerance you have for risk and/or the longer your time horizon, the greater the percentage you might be willing to risk on a single transaction.