# Is the 2 Percent Rule Suitable for All Traders?

The 2 Percent Rule says:

**NEVER RISK MORE THAN 2 PERCENT OF YOUR CAPITAL ON ANY ONE STOCK.**

But not all traders face the same success rate (or reliability as Van Tharp calls it). Short-term traders usually achieve higher success rates, while long-term traders achieve for higher risk-reward ratios.

## Success Rate (Reliability)

Your success rate is the number of winning trades expressed as a percentage of your total number of trades:

**Success rate = winning trades / (winning trades + losing
trades) * 100%**

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## Risk-Reward Ratios

Risk-Reward Ratio is your expected gain compared to your capital at
risk (it should really be called the *reward/risk ratio* because that
is the way it is normally expressed). If your average gain (after deducting
brokerage) on winning trades is $1000 and you have consistently risked $400
per trade (as in the earlier 2 percent rule example), then your risk-reward
ratio would be 2.5 to 1 (i.e. $1000 / $400).

**Risk-Reward ratio = average gain on winning trades /
average capital at risk**

## Confidence Levels

If we have three traders:

Trader: |
A |
B |
C |

Time frame: | Short-term | Medium | Long-term |

Success Rate: | 75% | 50% | 25% |

Risk-Reward Ratio: | 1.0 | 3.0 | 10.0 |

### Trader A

Trades short-term and averages 125% profit over all his trades.

Winning trades: | 75% * 1 | 0.75 |

Less: Losing Trades | 25% * 1 | -0.25 |

Average Profit | .50 | |

As a percentage of capital at risk | 50% |

### Trader B

Trades medium-term and averages 200% profit over all his trades.

Winning trades: | 50% * 3 | 1.50 |

Less: Losing Trades | 50% * 1 | -0.50 |

Average Profit | 1.00 | |

As a percentage of capital at risk | 100% |

### Trader C

Trades long-term and averages 325% profit over all her trades.

Winning trades: | 25% * 10 | 2.50 |

Less: Losing Trades | 75% * 1 | -0.75 |

Average Profit | 1.75 | |

As a percentage of capital at risk | 175% |

This does not necessarily mean that Trader C is more profitable than A. Trader A (short-term) is likely to make many more trades than Trader C. You could have the following situation:

Trader: |
A |
B |
C |

Time frame: | Short-term | Medium | Long-term |

Average Profit/Trade | 50% | 100% | 175% |

Number of Trades/Year | 300 | 100 | 40 |

Times Return on Capital at Risk | 150 | 100 | 70 |

Capital at Risk | 2% | 2% | 2% |

Annual % Return on Capital | 300% | 200% | 140% |

## Relative Risk

We now calculate the relative risk that each trader has of a 20% draw-down. Use the binomial probability calculator at http://faculty.vassar.edu/lowry/ch5apx.html:

Trader |
A |
B |
C |

Success Rate | 75% | 50% | 25% |

Probability of 10 straight losses | 0.0001% | 0.1% | 5.6% |

Obviously, the higher your success rate, the greater the percentage that you can risk on each trade.

Bear in mind that, with a higher risk-reward ratio, Trader C only needs one
win in 10 trades to break even; while Trader A would need five wins. However,
if we compare breakeven points, it is still clear that **lower success rates
are more likely to suffer from draw-downs**.

Trader |
A |
B |
C |

Number of wins (out of 10 trades) required to break even | 5 | 2.5 | 1 |

Normal Success Rate | 75% | 50% | 25% |

Probability of making a net loss in 10 trades | 2.0% | 5.5% | 5.6% |

## Low Success Rates

Although your trading system may be profitable, if it is susceptible to large draw-downs, consider using a lower percentage of capital at risk (e.g. 1 percent).