The Two Strikes Rule: A Risk Management Must in Trading

Here is something that has worked very well for me over the years and I can't believe that I have written about this before. I learned it pretty early on and I have stuck with it because it works for me.

It's called the 2 Strikes Rule.

You can probably guess what it is, but in this post, I'll dig into why I created it, why it works for me and how you can establish a similar rule. Remember, you are going to need to figure out what works best for you.

But if you are prone to revenge trading or if you find yourself giving back a lot of money on what seem to be perfect trade setups, I would highly recommend that you start with the 2 Strikes Rule and see how it works for you.  

The Two Strikes Rule Explained

To put it simply, the 2 Strikes Rule says that if I have two losing trades in a row on the same trading idea, I will not trade that idea again. 

It is very simple, but also very powerful.

Once I am stopped out twice on an idea, I let the idea go and look for other opportunities. I release any emotional attachment to the trade…good or bad.

From there, I put the trades in my trading journal and I don't think about the trades again. Creating this rule has helped me keep my losses to a minimum.

When I first started trading, I would chase the same idea several times, then wonder why I have a huge dent in my trading account. Implementing the 2 Strikes Rule put an end to that.

Why the 2 Strikes Rule Works

Even if you have backtested and forward tested your system and know what to expect, there may still be times where a trade can look a lot better than it is.

…multiple times.

For example, let's take a look at this chart. Let's say that you think that this former consolidation zone (gray box) will serve as resistance and price will turn around in this area. So you decide to take a short every time it looks like price will drop.

However, if you look at the chart, there are at least 3 different places where you could have got in and would have been stopped out.

On top of that, when price actually started to move down, there is no way that you could have made up your losses on that one trade alone. Of course, this is assuming that you are using a fixed risk percentage (which you should be).

So by only taking two trades per trading idea, you would have only lost 2R or two times your risk. This can be made back pretty easily on one or two trades.

However, once you start getting into 3R or more, it becomes a little more difficult to make that money back quickly. In addition, if you don't set any risk limits, trying to prove that you are right can be a slippery slope.

To me, it is best to just take two shots at an idea and if it doesn't work out, then release the emotional energy associated with it and look for other opportunities. 

…and there are always other opportunities! 

When the 2 Strikes Rule Does Not Work

It is just as important to understand when this rule might not be for you. There are some trading methods that can make the money back (plus much more) on the fifth or even sixth try.

These methods can have win rates in the 30% range, but sill make money. 

For example, trend following is a trading method that can involve many losses in a row, but when you catch a big trend, that can make your year. The bottom line is that you need to understand the mechanics of your trading method.

This means that you should backtest and forward test your system and really get to know it, before trading it live. If it is one of these trading methods that takes several tries to get right, then you can disregard the 2 Strikes Rule.

The 2-Strikes Rule Extended

But it doesn't stop there. When you lose two trades in a row, be sure to journal your trades to be sure that you took good trades.

Doing a check like this will allow you to take a step back and make sure that you are on track. This will prevent you from going on tilt.

Conclusion

The 2 Strikes Rule is something that has helped me a lot over the years and it can help you too. However, like anything else in trading, it might not work well for your trading method.

So take some time to experiment with this rule or some sort of similar rule that will keep you from going down the rabbit hole of revenge trading.