The 1% Rule
“How do I a make money in the currency market?” is something that I hear all the time whenever I meet retail traders just starting to explore FX. The truth of the matter is that there is no good answer to that question. Trading FX is such an individual pursuit that there are literally hundreds of different ways of approaching the market. You can be a long term investor and trade for positive carry. You can scalp furiously hoping to pick up a few pips every single day. Or you can trade positionally a few times each month, trying to take advantage of intermediate length themes.
In any case, I think that the novice retail traders are asking the wrong question. Winning in currency trading is often a matter of luck, but losing is mainly a function of skill. That’s why the key question in my mind is -- “How do I not lose money in the currency market?”. I don’t know if I can definitively answer even that question, but I do believe that if you follow one simple rule you may be able to stay alive long enough to find a strategy that ultimately works for you.
Losing money in the market is rarely the result of trading a bad strategy, but rather a function of making one bad trade that ultimately blows up your account. I bet if I were to audit 100,000 retail accounts that lost money in FX 95% of them would follow that path. Certainly many of my own accounts have been buried that way. This scenario happens so often because FX is a highly leveraged market and a wrong trade at a 20:1 lever factor (less than half the legal maximum) will wipe your account if the position moves just -5% against you. Contrast that with stocks where you can own dogs like RIMM or NFLX that can drop more than 50% off their highs and yet will still leave some equity in your account.
That’s why I believe that the only way to survive in FX is to follow the 1% rule. I first heard about the 1% rule from Larry Hite who is profiled in Jack Schwager’s Market Wizards book. Hite states, “The truth is that, while you can’t quantify reward, you can quantify risk.” And he quantifies risk by never betting more than 1% of his capital in any given trade. Schwager asks Hite about how he can trade so many different markets successfully and Hite replies, “We don’t trade markets, we trade money.” When asked how he differentiates a trade in gold versus a trade in cocoa, Hite replies, “They are both a 1% bet; they are the same to me.”
I’ve been trying to adhere to the 1% rule in my own intra-day trading and have seen a remarkable dampening of volatility especially as I try to develop new strategies that require a lot of trial and error in the market. Furthermore, just as Hite said, I now couldn’t care less about being right on any given trade. After all it is only a 1% loss. If I am wrong, I can quickly move on to try the next idea without digging myself into a deep financial hole. No doubt trading this way is considerably less exciting -- it is the equivalent of playing poker for pennies -- but that’s a small price to pay for staying alive to trade another day. After all I am in this for life and I would rather make slow and steady progress 1 basis point at a time instead of constantly blowing up in spectacular fashion chasing a jackpot that will never materialize.