In trading circles, there's a saying: The primary criterion for evaluating whether a trader is professional is not his profit level, but his risk control ability. Risk control has always been seen as one of the mandatory courses for professional traders, and many famous traders have always regarded risk control as an important indicator in their trading decisions.
Among these, the "1% risk rule" is a highly acclaimed risk management principle followed by many traders.
Adhering to this rule, when a trader is not in good condition or faces a challenging market, capital losses will be kept to a minimum, while there is still the potential for substantial monthly returns.
Overseas trader Donald Darwin is a staunch implementer and beneficiary of the 1% risk rule. He joined Wall Street at age 26 and achieved enviable results in his first three years as a trader, with earnings exceeding 2 million dollars.
In the early days, Donald was also very confused, losing hundreds of thousands of dollars in just six months when he first started trading. This made him very troubled and puzzled until he calmed down and reviewed his trades over the past six months.
Ultimately, he discovered that the main reason for his losses was not inappropriate strategies but a neglect of the importance of risk control.
Recently, in an interview with a reporter, he disclosed his secret to profitability, emphasizing his solid trading experience and, more importantly, his risk control practices, particularly the consistent application of the 1% risk rule.
Next, let's explore the charm of this rule.
01 What is the 1% risk rule?
The 1% risk rule refers to the maximum risk assumed per trade, also known as single trade risk by those who have studied risk management.
Under the 1% risk rule, you can only risk up to 1% of your trading account's balance on any single trade.
For instance, if your trading account has $10,000, the total loss in each trade should not exceed $100 (i.e., 10,000 x 1%).
This is achieved by adjusting your position size so that when a stop-loss is triggered, your total loss is only equivalent to 1% of your trading account.
Although under the 1% rule, your total risk should not exceed 1% of your trading account, you can also take on lesser risks. Whether you should assume less than 1% risk mainly depends on your position size.
Traders with high trading amounts usually take on risks below 1% of their account funds, for instance, 0.5%.
02 Why use the 1% risk rule?
The 1% risk rule is designed to avoid significant losses from a single trade, allowing you to stay in the market longer.
If novice traders follow the 1% risk rule, many of them will start making real profits after a year of trading. Of course, when assuming 1% risk, you should set a profit target of 1.5%-2% for each trade.
After trading for several days, even if your success rate is 50%, you can still achieve a few points in return.
However, many novices tend to risk large amounts of capital in a single trade when they first start. The consequence is that one or a few losing trades could wipe out their accounts.
After a margin call, they may avoid funding a new account out of pride, or they make emotional decisions to recover their losses.
This is why many beginners cannot make stable profits.
But if they follow the 1% rule, risking only a small portion of their accounts in any single trade, their losses will be greatly reduced.
As forex traders, we cannot control the outcome of the next trade or the market's direction, but the one thing we can control is the risk we take on.
Although higher risks mean higher profit potential, as a trader, your goal should be to control risk and achieve consistent profits. If you want to double your account with every trade, going to a casino might be quicker.
03 Risk-Reward Ratio and Single Trade Risk
The risk-reward ratio refers to the ratio between the points you expect to profit (take profit) and the points you expect to lose (stop loss) in a trade.
For example, if you risk 20 points in a trade and stand to potentially gain 40 points, your risk-reward ratio is 1:2.
Let's assume:
If you buy a stock at $50 and set the stop-loss price at $45 and the take-profit price at $55, your trade's return risk ratio is 1, meaning you risk $5 to gain $5.
Now, if you buy the same stock but set the profit target at $60 and the stop-loss at $45, the risk-reward ratio for this trade is 2:1, meaning you risk $5 to gain $10.
The risk-reward ratio is closely related to each trade's risk. If you define your preferred risk-reward ratio in your trading plan, you can easily calculate the potential profit for each trade.
When combining the risk-reward ratio with single trade risk, if you use a 2:1 return rate and 1% risk per trade on a $10,000 account.
Then, your potential loss for any trade will not exceed $100, while your potential profit will be at least $200.
04 How to use the 1% risk rule?
To apply the 1% risk rule in your trading system, you must know how to calculate the correct position size. This is achieved by setting stop-loss, calculating each point's dollar value, and adjusting the position size accordingly.
1 Stop-Loss
A stop-loss order is an order to automatically close a position when the price reaches a predefined level. The stop-loss is used to control trading losses and plays an essential role in the 1% risk rule.
Note: Do not change the size of your stop-loss to meet the 1% single trade risk. The stop-loss should be based on your analysis, not the maximum amount you're willing to risk.
The position size ensures the normal operation of the 1% rule, not the stop-loss setting.
There are four types of stop-loss:
• Percentage-based stop-loss: To protect trading funds, traders are advised to risk no more than 2% per trade.
This means regardless of market conditions, the risk won't exceed 2% when setting a stop-loss.
• Volatility-based stop-loss: Setting a stop-loss based on price volatility is a cautious approach because it relies on the past price movement of a currency pair, which can be a good indicator of future performance.
• Time-based stop-loss: As the name suggests, a time-based stop-loss is based on time. Time-based stop-loss is usually combined with other types of stop-loss orders to avoid overnight or weekend positions.
• Chart-based stop-loss (support and resistance levels): Lastly, a chart-based stop-loss is set based on key technical levels. Based on experience, chart-based stop-losses have the best returns among all types.
Chart-based stop-losses can be placed above key resistance levels or below support levels, above/below trend lines, Fibonacci levels, pivot points, or applied to any other technical tool.
2 Position Management
Once the size of the stop-loss point is determined, it is time to manage the position size. As previously mentioned, your position size ensures you meet the single trade risk rule.
For example, suppose your stop-loss is 50 points away from your entry price.
Your trading account size is $10,000, and under the 1% risk rule, you want to risk only 1% of your account on any single trade.
To meet this condition, traders won't adjust the stop-loss but the position size.
Since our stop-loss is set 50 points away from the entry price, and the total amount we want to risk is $100, each point should be equal to $2 in dollar value.
From experience, the point value for a position size of 1 lot (1 standard lot is $10,000) is $10. This means our position size should be 0.20 lots.
05 A trading example of the 1% risk rule
To illustrate the 1% rule more clearly, let's look at another example.
Suppose EUR/USD is trading at 1.1050, and you want to go long after a breakout from a symmetrical triangle.
For a $4,000 account, you know your total risk per trade should not exceed 1%, or $40.
Using a chart-based stop-loss, you determine the best stop-loss point is just under the symmetrical triangle, a distance of about 40 points from the entry price.
Now you have all the necessary data points to calculate your position size. Separating the per trade risk ($40) by the stop-loss points (40 points) gives you the dollar value per point. This step returns 1 dollar per point.
Since the point value for a standard lot of EUR/USD is $10, under the 1% rule, the maximum position you can open is 0.10 lots.
06 Finally, it is clear that a critical factor in applying this rule is long-term practice, so choosing a reliable and trustworthy platform is essential for the application of the 1% risk rule.
Donald Darwin describes the relationship between trading platforms and the 1% risk rule as follows:
"The key to applying the 1% risk rule is having enough patience to stick to the strategy. During this period, a reliable and stable trading platform allows me to move forward without worries, eventually achieving the goal of long-term and stable profitability."
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