Ugly losses stick like sore thumbs out of most accounts. Traders who review their records usually find that a single terrible loss or a short string of bad losses did most of the damage. Had they cut their losses sooner, their bottom line would have been much higher. Traders dream of profits but often freeze like deer in the headlights when a losing trade hits them. They need rules that tell them when to jump out of harm's way instead of waiting and praying for the market to turn.

Good market analysis alone will not make you a winner. The ability to find good trades will not guarantee success. No amount of research will do you any good unless you protect yourself from the sharks. I've seen traders make 20, 30, and once even 50 profitable trades in a row, and still end up losing money. When you're on a winning streak, it's easy to feel you've figured out the game. Then a disastrous loss wipes out all profits and tears into your equity. You need the shark repellent of good money management.

A good system gives you an edge in the long run, but there is a great deal of randomness in the markets, and any single trade is close to a toss-up. A good trader expects to be profitable by the end of the year, but ask him whether he'll make money on his next trade and he'll honestly say he doesn't know. He uses stops to prevent losing trades from hurting his account.

Technical analysis helps you decide where to place a stop, limiting your loss per share. Money management rules help you protect your account as a whole. The single most important rule is to limit your loss on any trade to a small fraction of your account.

Limit your loss on any trade to 2% of equity in your trading account.

The 2% Rule refers only to your trading account. It doesn't include your savings, equity in your house, retirement account, or money in the Christmas club. Your trading capital is the money you have dedicated to trading. This is your true risk capital, your equity in the trading enterprise. It includes cash and cash equivalents in the account, plus today's market value of all open positions. Your system should make you money, while the 2% Rule lets you survive the inevitable drawdowns.

Suppose you're trading a $50,000 account. You want to buy XYZ stock, currently trading at $20. Your profit target is $26, with a stop at $18. How many shares of XYZ you are allowed to buy? Two percent

of $50,000 is $1,000, the maximum risk you may accept. Buying at $20 and putting a stop at $18 means you'll risk $2 per share. Divide the maximum acceptable risk by the risk per share to find how many shares you may buy. Dividing $1,000 by $2 gives you 500 shares. This is the maximum number, in theory. In practice, it has to be lower because you must pay commissions and be prepared to be hit by slippage, all of which must fit under the 2% limit. So, 400 rather than 500 shares is the upper limit for this trade.

I've noticed a curious difference in how people react to the 2% Rule. Poor beginners think this number is too low. Someone asked me at a recent conference whether the 2% Rule could be increased for small accounts. I answered that when he goes bungee jumping, it doesn't pay to extend the cord.

Professionals, on the other hand, often say 2% is too high and they try to risk less. A very successful hedge fund manager recently told me that his project for the next six months was to increase his trading size. He never risked more than 0.5% of equity on a trade-and was going to teach himself to risk 1%! Good traders tend to stay well below the 2% limit. Whenever amateurs and professionals are on the opposite sides of an argument, you know which side to choose. Try to risk less than 2%-it is simply the maximum level.

Whenever you look at a potential trade, check whether a logical stop on a round lot or a single contract would keep you on the right side of the 2% Rule. If it would put more money at risk, pass that trade.

Measure your account equity on the first of each month. If you start the month with $100,000 in your account, the 2% Rule allows you to risk a maximum of $2,000 per trade. If you have a good month and your equity rises to $105,000, then your 2% limit for the next month is-how much? Quick! Remember, a good trader can count! If you have $105,000 in your account, the 2% Rule allows you to risk $2,100 and trade a slightly bigger size. If, on the other hand, you have a bad month and your equity falls to $95,000, the 2% Rule sets your maximum permitted risk at $1,900 per trade for the following month. The 2% Rule lets you expand when you are ahead and forces you to pull in your horns when you do poorly; it links your trading size to your performance. What if you have several trading accounts, for example, one for stocks and another for futures? In that case, apply the 2% Rule to each account separately.

Futures - OK to Trade Spreadsheet

Imagine two traders, Mr. Hare and Mr. Turtle, both with $50,000 accounts, who are looking at two futures markets-S&P 500 and corn. The agile Mr. Hare notices that the average daily range in the S&P is about 5 points, worth $250 each. The daily range in corn is about 5 cents, worth $50 each. He quickly figures that if he catches just a half of a day's range, he'll make over $500 per contract in the S&P, whereas the same level of skill will bring him just a little over $100 in corn. Mr. Hare calls his broker and buys two contracts of the S&P.

The cautious Mr. Turtle has a different arithmetic. He begins by setting the maximum risk in his account at 2% or $1,000. Trading the S&P, moving over $1,000 a day with such a small account, is like grabbing a very large tiger by a very short tail. If, on the other hand, he trades corn, he'll have a lot more staying power. That tiger is smaller and has a longer tail, which he can wrap around his wrist. Mr. Turtle buys a contract of corn. Who is more likely to win in the long run, Mr. Hare or Mr. Turtle?

To find out which futures markets you may or may not trade, meas ure your equity against the recent level of market noise. Begin by cal culating 2% of your account. Measure the level of noise with the SafeZone indicator, calculate its 22-day EMA, and translate that into dol lars. Do not trade any market whose average noise level is more than 1% of your equity. If you follow this rule, you'll trade relatively sedate markets where you can safely place your stops. Why 1% and not 2%? Because your 2% stop will have to be more than the average noise level away from the market.

The first column in the spreadsheet in Table 7.1 lists the market, the second the value of one contract, the third the current SafeZone indicator, and the fourth multiplies SafeZone by two. The fifth column lists 2% of the account value, in this case $30,000. The last column compares the value of SafeZone multiplied by two to 2% of the account. If the latter is greater than the former, that market is OK to trade.

The values in Table 7.1 are current as this is being written, but have to be updated monthly because volatility changes and SafeZone with it. The exchanges occasionally modify contracts and change unit values. Use this table only as an example and a starting point. Do your home work, plug in the current numbers, and find out which contracts you may or may not trade.

If you cannot afford to trade a certain market, you can still download it, do your homework, and paper trade it as if you were doing it with real money. This will prepare you for the day when your account grows big enough or the market grows quiet enough for you to jump in.