Do I only risk 2% of the size of the order or the size of the order on margin. For example, let's say I have $100K in an account and but 100 shares of a $100 stock for $10,000. Do I put a stop in at $9,800 (2% of $10,000 subtracted from $10K) or $9,900 (2% of $5,000 subtracted from 10K)?
According to that rule of thumb, your risk should be NO MORE than $2,000, which is 2% of the account equity of 100K. However, that should not define your stop, which should be based on the characteristics of the instrument you are trading. But wherever the stop is, it should not open you to a loss of more than 2% of overall equity. IMO, a potential 2% loss is too much to risk on any trade.
So you mean my trade size is limited to 2% of account equity, regardless of margin? Wouldn't that mean, for futures, needing a humongous account, as most futures are traded on like 3 or 4 percent margin?
That's a common mistake.. According to the rule of thumb, your trade RISK should be no more than 2% of your equity (not the trade size, margin used, etc.). To use your example on buying a $100 stock. Risking 2% of a $100K account equates to $2000 RISK. Using lindq's excellent advice of using market-based stops, say you decide at a stock price of $95 you were wrong and need to be stopped out. Taking the $2000 risk and dividing by the risk per share of $5 (100-95) gives you 400 shares. If you buy 400 shares at $100 and get stopped out at $95 you'll lose $2000 (slippage?). Of course this is a grossly simplified example. Another consideration is diversification in your account. Using the above example, do I really want to tie up $40,000 of my capital in one trade? If not, adjust your risk. Also, the 2% risk is a rule of thumb, born from those trading daily time frames I suspect. If you bang out 5 trades in a day you could find yourself down 10% in your trading account. Can you live with that? If not, adjust your risk. This is basic risk/position management. There are hundreds of caveats. Most people I talk to either 1) don't practice risk management, or 2) complicate it to the point of absurdity. I try to fall somewhere in between. But I have NO doubt my early attention to simple risk management saved me. Live to fight another day...
Let's work another example. You'll still have a $100K account and you'll still risk 2% of the account on one trade, buying a $100 stock. However, in this example you decide at a stock price of $99 (rather than $95) you were wrong and need to be stopped out. Taking the $2000 risk and dividing by the risk per share of $1 (100 - 99) gives you 2000 shares. Buying these 2000 shares at $100 per share will cost you $200K, hello mister 2X leverage. You've used up all the cash in your account AND all your margin buying power, on this one trade.
Ok, just so I have this straight, I risk 2 percent of the equity value of the account per trade, just forget the margin -- for this calculation, right?
Yes, right, but... 2% is a rule of thumb and may be too high for high-frequency trading. Also, pay attention to how much capital you're tying up (per horribilicus' example).
If you have a well defined trading method, you can calculate the maximum risk you should take with each of your trades starting from your ratio of winning vs. losing trades, your average win and average loss, and the maximum drawdown you can stomach. There are many places were you can find out how to do it. One is THIS. If your trading results are not consistent, you shouldn't risk more than .5 to 1% of your equity on each trade (when your trades are loosely correlated). To size your trade divide your $ maximum risk by your $ stop loss differential. Example: equity = $10,000 max risk per trade (calculated or rule of thumb) = 1% => $10,000 * 1% = $100 current (long entry) price = $50 stop loss at $48 (based on your analysis) risk per share = $50 - $48 = $2 => $100 / $2 = 50 shares