In the 4th test of the 2001 Ashes tournament, the Aussies were 155 runs ahead of England in the first innings after bowling them out at 309. With aggressive bowlers like Shane Warne and Glenn McGrath on the Aussie side, they thought they could overturn the English by adding only 150 + more runs. Despite having four more wickets in hand, Aussies declared the second innings on 176 runs thereby, setting a target of 314 runs, formed from the remaining runs of the first and second innings. To the Aussies’ surprise, the English won the match by scoring 315 runs.
The readers till now must have been startled that in a finance story, why is he/she reading a cricket story. The answer lies in its similarity with the stock market.
Aussies did one mistake, by not knowing where to stop. With four wickets in hand, had they declared or stopped a little later, they could have made the target difficult for England.
The art of knowing where to stop or stop loss is crucial in both cricket and while trading in the stock market.
While trading, we use stop loss to limit the uncertainty impacting the investment. It is a point where buyers sell their stock to exit if the market turns its tides. Over the years, traders have developed several stop-loss strategies to cushion losses, out of which one is the 2% rule.
What is the 2% rule in the stock market?
The 2% rule in the stock market is an investing strategy where the investor will not risk more than 2% of their available trading capital on any single trade. For instance, say we have a trading capital of Rs 10000 so its risk per trade is 2% of Rs 10000 i.e. Rs 200. This value of Rs 200 is the maximum permissible capital risk which the investor can afford. Consider a scenario, where the 2% rule we have not applied. Say, we want to invest Rs 10000 to trade in the stocks of pharma and there is a 60 % chance of doubling the money but at the same time there lies a 40 % probability of losing the entire money. The 2% rule helps us to take calculated risks while investing.
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The art of knowing where to stop or stop loss is crucial in both cricket and while trading in the stock market.
We have not added here the brokerage, but it should be included in the calculation to accurately determine the maximum capital to risk. This maximum permissible risk amount is then divided by the stop loss amount to determine the number of shares to be purchased.
How does the 2% rule in the stock market work?
Say, you are an investor having an amount of Rs 50,000 as trading capital.
Now, the risk capital at 2% = Rs 1000 (50,000 * 0.02) per trade
Say, we have a brokerage charge of Rs 50 on each buy and sell to which the final risk capital becomes = Rs 900 (1000- {2*50})
Suppose we are trading on shares where the price per share is Rs 20 and we want to place the stop loss at Rs 15. Now, the risk per share becomes Rs 5 (20-15). Adding to the risk per share is the slippage cost of say, another Rs 2 thus totalling the risk per-share value to be Rs 7 (5+2). Slippage is the difference between the expected price of a trade and the price at which the trade is executed.
So, the maximum number of shares that we can buy = Maximum permissible risk / risk per share = Rs 900/ Rs 7 = 128.5 ~ 128 shares.
So, the total investment to buy 128 shares will become = No. of maximum shares available to purchase X price of each share = 128 * 20 = Rs 2560.
Is the 2% rule applicable to all the traders?
With the 2% rule not, all investors can get the same success rate. Short-term investors using this rule achieve higher success rates, while the risk to reward ratio for long-term traders is high.
