The Importance of the 5% Rule

03/19/2013 9:00 am EST

Focus: FOREX

Risk management is an important skill for every trader to master, writes Walker England of DailyFX.com, and he will approach containing forex risk using the 5% rule.

One of the most difficult trading traits for new forex traders to master is risk management. Questions about stop placement are common place, but often traders forget the bigger question when it comes to risk. Before you enter the market or consider opening new positions ask yourself the following question.

How much of my account should be at risk at any given time?

Most professional traders consider the 5% rule when managing their trading positions. This rule implies that if all open positions are closed the TOTAL loss to an account would not exceed 5% of their account balance. Below you will find using a basic calculation using the 5% rule on a $10,000 account. That means on any give trading day, if all positions are closed at a loss this trader will only experience a loss of $500.

chart
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While no one wants to experience a 5% drawdown in their account balance, remembering the above equation can help traders from completely devastating their account. In the above example, even after losing $500, the trader still has the remaining balance of $9,500 available for trading. Let’s take a look at what can happen when a trader ignores these rules.

chart
Click to Enlarge

It should be noted that the 5% rule does not equate to risking 5% of your trading account on one particular trade. Imagine if you had five trades open, each risking 5% of your trading account. If all positions were closed for a loss that means you would be assuming a loss of 25% of your total account size. To put things in perspective, using the starting balance of $10,000 mentioned above, that would equate to a loss of $2,500 and only leave you with a balance of $7500! This is a scenario that every trader can manage to avoid if they apply this one simple rule.

By Walker England, Trading Instructor, DailyFX.com

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