The 1% rule is a key risk management strategy for swing traders, where a trader aims to limit each loss to 1% of their portfolio's value.
This simple, but nevertheless often overlooked rule helps ensure that
traders have enough capital to keep trading and avoid significant losses that could wipe out their account. To implement this rule, position sizing based on the volatility of the asset being traded is essential.
Determining Position Size Based on Volatility
The first step in sizing positions according to the 1% rule is to determine the asset's volatility.
Volatility refers to the amount of price movement an asset experiences over a given period. To calculate an asset's volatility, traders can use historical data such as the standard deviation of daily price movements.
Once you have determined an asset's volatility, you can set your position size so that a stop loss order will limit your potential loss to 1% of your portfolio. To do this, you need to calculate the number of shares or contracts you can trade based on the distance between your entry price and your stop loss level.
For example, let's say you have a $50,000 portfolio and want to limit each loss to 1%, which is $500. You are considering buying 300 shares of an ETF called XYZ at $50. The ETF has an average daily price range of 1%, so you decide to place your stop loss order 2% below your entry price, or $49 to protect yourself from deeper drawdowns.
In this scenario, your potential loss would be ($50 - $49) x 300 shares = $300. This amount is less than your desired 1% limit of $500, so you can proceed with the trade.
Adjusting Stop Loss Levels Based on Volatility
It's important to note that an asset's volatility can change over time, and stop loss levels should be adjusted accordingly. For instance, if XYZ's average daily price range widens to $3, you may need to adjust your stop loss level to maintain a 1% risk level.
To do this, you would recalculate the number of shares or contracts you can trade based on the new volatility and your desired 1% risk level. In our example, if XYZ stock's average daily price range widens to 2%, you might place your stop loss order 3% below your entry price, or $48.5 per share. This would result in a potential loss of ($50 - $48.5) x 300 shares = $450, which is still within your 1% risk limit.
Closing Thoughts
The 1% rule is an important risk management concept for swing traders to consider within their approach. By sizing positions based on the volatility of the asset being traded and placing stop loss orders to limit potential losses, traders can ensure they never lose more than 1% of their portfolio value on any single trade.
Following these principles allows swing traders to better protect their capital and increase their chances of long-term success in the markets by managing risk first and foremost.