Ask Colin

Could you explain the 6% rule (as opposed to the 2% rule) and suggest additional readings?

You could be referring to either Dr Alexander Elder's methods or to my methods, both of which have 2% and 6% rules, but are quite different with respect to the meaning of those percentages. I will explain both:

The Elder Method

Dr Elder uses a money management (position size) algorithm based on 2% of trading capital. Essentially, you determine your entry price and your stop loss level. The difference between these two prices is your risk per share. You then calculate how many shares you can buy if your total risk is no more than 2%.

Say you have $100,000 trading capital. You can risk 2% of $100,000, which is $2,000. If you buy a share selling for $1, with a stop-loss at 95c, your risk per share is 5c. The number of shares you can buy is 2,000 / .05 = 40,000.

Dr Elder's 6% rule is that you can only lose 6% of your trading capital in a month. So, you add up what you have already lost and the risks on your open positions and once they reach 6% you cannot take any more trades in the month until one of your open positions moves higher so that you can raise your stop-loss level or you take some profits.

If your trading capital is $100,000 as above, then you are only allowed to lose $6,000. Now, suppose that in a month you have profits of $3,000 and losses of $5,000. You have net losses of $2,000 or 2%. If you have two open positions, one risking 2% and the other risking 1%, you can not risk more than 1% on any additional trade until the situation changes or a new month starts.

Once you have lost 6% in a month in actual losses, you must stop trading.

This is fully explained in Dr Elder's book Come Into my Trading Room.

My Method

I use the same percentages as it happens, but in a totally different way.

I only risk 1% on any one trade (not 2% as Dr Elder does). However, there are some differences in the way those two percentages are calculated - Dr elder includes an allowance for brokerage and slippage in his 2% (I ommitted that above to keep it simple), whereas I do not. In practice the differences may not be as great as appear on the surface between Dr Elder's position size and mine..

My percentages relate to diversification, an aspect that is absent from Dr Elder's method. In its simplest terms, I will not take a position that is less that 2% of my capital. That ensures that the position is worthwhile.

However, I will not build a position that is more than 6% of my capital at cost price. That ensures that my portfolio is not too concentrated.

Suppose that we again have investment capital of $100,000. In the trade we looked at above, Dr Elder would buy 40,000 shares (simplified by not allowing for brokerage and slippage). Since I only risk 1%, my position sizing calculation would suggest a maximum of 20,000 shares. Since 20,000 shares would cost $20,000, that would be 20% of my portfolio and unacceptably above my 6% rule. So, I would only buy a maximum of $6,000 / 1.00 = 6,000 shares.

I also have a strategy of staging into a position, so in practice I would not commit the entire $6,000 to the first buy. However, I would not commit less than $2,000, or 2,000 shares in this case.

Now supposing that I had another share I could buy at $10.00, but my stop-loss had to be at $7.00. My risk now is $3 per share. I would be allowed by my position sizing calculation to buy 1,000 / 3 = 333. That parcel would cost $3,330 which is 3.3% of my capital. That would be the most I would be allowed to buy, even though I was able to put up to $6,000 into a trade.

Now suppose that I had another share I could buy at $4.00, but my stop-loss had to be at $1.70. I am now risking $2.30 per share. I would be allowed to buy a maximum of $1,000 / 2.3 = 435 shares on my position sizing rule. However, the parcel would only be worth 435 x $4 = $1,740. Since that is less than my minimum investment of 2%, I would not be able to take the trade and have to wait for another entry point with a closer stop-loss, or find another share to trade.

My methods are fully described in my videotape Building Wealth Through Shares, details of which are on my web site.

In both cases, these rules are only part of an overall strategy and only make sense in the context of the total method. They should not be adopted without due consideration of the strategy and settings adopted to control the other risks in trading.