This could also be the 2%, 3%, 4% or 5% risk rule. The 1% risk rule means you don’t risk more than 1% of your capital on a single trade. There are two ways traders can apply the 1% (or whichever percentage they choose) rule. The first is to only use 1% of capital to buy a single asset (Equal Dollar Method). The second is to use as much capital is needed for a trade, but apply a stop loss to the position so no more than 1% of the account is lost if the trade goes the wrong way (Equal Risk Method).
Further Explanation of the 1% Risk Rule
The rule is applied so that no single trade causes a massive loss in the account.
Day traders and swing traders typically only risk up to 1% of their account on any single trade, and use the stop loss approach (Equal Risk). For example, a day trader with a $30,000 account can risk up to $300 per trade if risking 1%. Assume they buy a stock at $15, expecting it to go higher, and place a stop loss (which exits the trade) if the price drops to $14.90. The trader buys 3000 shares, because if they lose the $0.10 per share ($15 – $14.90) on 3000 shares, they have only lost $300, or 1% of their account. For more on how this works, see How to Determine Proper Position Size When Trading.
Investors, who plan to hold an asset for long periods of time, typically use the Equal Dollar model, and use 1% to 5% of their trading capital to purchase a single asset/trade. If an investor has a $100,000 account and only wants to risk 1% of capital on each trade, they would only invest up to $1,000 (1%) on any single trade. If they are willing to risk 5%, they could invest up to $5,000. If the asset falls to zero, they have only lost 1% to 5% of their account. Once you know the amount of capital you are willing to risk, then convert it into a dollar amount. Take the dollar amount and divided it by the share price to attain the number of shares you can buy (remember to factor for commissions).
Further Reading on This Topic