Starting with the 2% rule.
Simply stated, the 2% rule is: Do not risk more than 2% of your capital in one trade. This is supposed to ensure that if you get it wrong and you are forced to stop out, you don't do too much damage to your account. What this rule does not mention is how many trades you can have open at any give time or how many times you are allowed to gear yourself (your portfolio).
So let's imagine that, like most new traders (not saying you're a new trader, just saying that there are a lot of newbie traders out there and hopefully this will help them - now the flow of this sentence is all wrong, so start it again and skip this part), you subscribe to the 2% rule and and you put on a few trades. Sticking to the 1:2 risk:reward ratio, it goes pretty well. You're risking 2% and banking 4%. Eventually you're sitting with 11 trades open, each risking 2%. Now, if all 11 trades go against you (let's say that you are only long) and the market has a week like it did last week, odds are that (in the worst case scenario) all your trades are now at their stop loss levels. Which means that you have just taken a 22% smack in a market that is down 5% or so. I have watched this happen in the past so I know it is possible, or rather, probable that it can and will happen to anyone. But that's not all... because what most people don't realise is that there are brokerage costs to include in your calculations, so what should be a 22% loss is closer to a 30% due to brokerage and slippage.
What the 2% rule does not account for is gearing. Mostly, the position size is calculated based on the entry price, stop loss level and amount (2%) that will be lost if the stop loss is hit. This leads the trader to believe that he/she is safe because they have predefined the risk and have a stop loss. What they don't realise is that they are not managing their exposure efficiently. And that is where I believe the problem lies.
1:2 risk:reward ratio
In theory there is nothing with this. The only problem I see here is that it will sometimes get you out of your trades too soon. Sometimes there is a 150% run for the year, as was the case with Coronation Fund Managers (CML) last year. Letting go of that big winner too soon is one of my biggest weaknesses and I am working on learning to hold onto winners longer.
Another note worthy of being mentioned is that, depending on the strategy, trades with risk reward ratios of 15:1 can be very profitable. It sounds crazy.. risk 15% to make 1%!? Well not exactly, but take for example the strategy I have been trading for a little while now. It allows me to hold a share and survive a 24% drawdown in the share price (or index). And by survive I mean that if the share or index falls 24%, the strategy will only be 12% in the down. This does exclude brokerage, so with that included the final 'risk' that it takes is 15% - 16% per share/index that the strategy is deployed on. The weakness of the strategy is that if the market trends really strongly, it could (and probably) will underperform. Although in a volatile market the strategy performs really very well, and it ensures that you are hardly ever geared, and that you catch the big move (albeit only with a small position).
I guess I have no criticism on the 1:2 risk:reward rule at all. It is a good rule and should be incorporated in some way or another into any trading strategy. I guess I just haven't figured out how to put it in mine yet. Another piece of the puzzle I need to work on.
We should be thinking in terms of exposure
The way I see it, and I could be wrong here of course, is that in order to survive the crashes and sustainably make profit, we need to think in terms of exposure. If you have R100k in your account, for fuck sakes don't go out and buy R700k worth of stock. It's stupid. Also, being long R300k and short R300k does not nett off to zero exposure... it's a R600k position and for a R100k account, it's too big.
I know that trading in derivative instruments, be it CFD's or SSF's, allows you to gear. It leads to thinking like; "well, I can take a bigger position because I have the margin for it, besides it's not that much risk anyway" and, "I'm long and short at the same time, I'm safe". Remember that you are paying interest on that position for every day you hold it. The only real bonus with trading derivatives is that the brokerage rates are lower. Remember that. I'm not talking about index futures or options here.
As a general rule of thumb, remember this: The lower the market goes, the higher you can gear. As long as you can afford to ride it down 50% from the high. And don't add to a loser!
So what about stability?
Well I guess that this is what it all comes down to: designing a system, or developing a method that you know will be able to survive a 50% market correction. Not only that, but a system that will leave you with enough free cash to be 'long the rocker' when the market is down there.
In a sense, you need to find a way of trading that will keep your account stable. It needs to enjoy the upside when the market rallies and not fall as hard when the market comes down. Stability is more important than massive returns in my book. The trick to surviving in the market is to accumulate profit. Booming and Busting is not how fortunes are made. Slow steady growth is the key. It might not always beat the market, but keep the volatility of your portfolio low and the equity curve pointing up and in a few years you will have grown your capital in a relatively stress free way. Look at Berkshire Hathaway. It didn't beat the S&P500 last year, but it is stable and on the up, and also one of the greatest portfolios in the world.
If you have questions or comments, please feel free to ask in the comments section below and I will be sure to get back to you.
>Peace and Love!
