24 July 2020
Trading is a wonderful world. Many think it is some sort of money pit. And because of this unfounded opinion, many go into the space and lose hundreds of dollars in the process. How can investors avoid this? How can you avoid losing your money? The answer is simple: education. By studying candlesticks, patterns, and trends, the risk of losing your money decreases. Yet, risk management goes far beyond reading a chart. As we delve deeper into the subject, we come across a rule.
This is the 5% rule. What is it? What does it do? We will explain it in this article.
What is Risk Management?
First off, we must define what risk management is.
Risk management allows you to handle the implicit and explicit threats of the markets. This will help you make better profits and reduce losses.
First of all, these rules do not mean you can play with more than you can lose. Stock and crypto markets are very volatile and could cause you to lost quite a large chunk of your money.
After acknowledging that you are not risking more than you can afford, the next step is to set your stop loss. Your stop loss will prevent you from losing too much money.
What is the 5% Rule?
So, let’s imagine a simple situation. You have deposited some Bitcoins on your exchange. You are ready to trade. You plan to make as much money as you can. But truth is, you cannot win every single trade. Knowing that you cannot win every trade, you want to cut your losses short, right? how are you going to do that? This is where the 5% rule enters the game.
The 5% rule allows you to control your losses. With it, your biggest trading loss would be the equivalent of 5% of your balance. Notice that this rule does not imply that this is a fixed percentage – that means it could be 5%. It depends on how risky you are as a trader.
How Does it Work?
So, to put to work this rule, the very first thing you need to do is define how much you want to risk per trade. Let’s say you decide to risk 3% of your total capital per trade.
Let’s use an example again. Let’s imagine you decide to trade and your initial balance is US$ 2,500. Great, so you now have your collateral. Now, after applying this rule, your 3% is US$ 75. That means that in your first trade, you risk losing only US$ 75 out of your total balance.
This will prevent you from losing all your money should the market take a turn. Likewise, while the percentage will not change unless you tell it, the amount you risk will be higher or lower depending on how well you do in the market.
Finally, there are some other things you should know about this rule. In the same way, you should also know that if you risk 3%, you should aim to win, at the very least, 3%. You should not risk 3% if your profit margin is around 1%. We have already said that the percentage depends on you, and that is fine. Yet, you should always follow this rule if you want to be a successful trader.