Most traders advise that one should only risk 1-2% of one's account per trade. My questions: 1) Does that figure in leverage? i.e. do you take 1% (of let say 10,000 USD account) which is 100 USD and then leverage that amount, or does the 1-2% figure already account for leverage used? 2) I'm not sure I understand why 1-2% is the limit for traders when investors diversify 20-30% of their wealth into stocks, gold, etc. Please clarify. Thank you.
The whole point of this is to not risk more than 2% per trade. That is, if the trade goes against you then you won't lose more than 2% of your capital. The reason for this is that it would take a mighty losing streak to blow up your account if you only risk 2% per trade. Investors diversify not only across asset classes but also within asset clasess so that 30% allocation to stocks is spread over 10-20 stocks.
I remember during year 2001 experiencing 19 losing trades out of 20 entries. If I bet 1% per trade then I might experience a 19 % loss. If I bet 2 % per trade then I might experience a 38 % loss. Some of my decision to bet maximum 2 % of account equity on a trade is associated with my personal tolerance of volatility.
How much you risk depends on your personal risk tolerance. Many successful short term investors (or traders) recommend only risking 1 or 2%. This is because trading is far from an exact science - it's based on having a chance, maybe 50% chance, maybe 75% change, on making money on a trade. No system gives you 100% chance of making money. Some traders will make 10 trades in a row or maybe 20 when the market just goes against them. It's all about the laws of probability. If you flip a coin 1,000 times there will be times when it comes up heads 20 times in a row - it doesn't happen often but it does happen. If you are only risking a small amount of your entire available balance then you have the best chance of staying alive. As a trader, first you have to stay alive, then you can make some money. The 2% rule counts against your own money not margin, and is based upon your Stop Limit. Say you have an account of $10,000 margined to $20,000 and you bought 200 shares of one stock priced at $100. If you set your Stop Limit at $99, you could lose $200 if the trade goes against you, plus transaction costs of maybe $15. That $215 loss would be about 2% of your entire account. So that is the 2% rule. Two things - first, it may sound crazy that you could ever have such a string of bad luck. It can and it does happen. Second, you have to remember that with each loss you need to earn back much more to get back to where you used to be. If you have $10,000 and it goes down 20% to $8,000, you need to get a 25% return just to get back to $10,000 because you're working with less capital now. This was a long post, but hopefully it helps.