What Is The 3-5-7 Rule In Trading?
In financial trading, success is not determined by the peaks of your strategy but the return you make at the end of the day, and the way to sof instant funding is not only to know when to enter the market but also when to exit.
This is where risk management becomes so important, but given the complex intricacies of investing, knowing where to set stop-loss orders, drawdown limits and how to diversify your portfolio can be quite difficult to completely grasp at first.
The best way to develop your risk management skills is to trade, network with other investors and learn the forex market, but there are some simple rules of thumb you can use to get started.
The 3-5-7 Rule is a position-sizing concept that can help you avoid a strategy so risky it requires almost impossible luck to succeed, whilst also not being so conservative that you do not make a return at all.
To explain why it works, we need to break down all three numbers before we examine how you can apply these principles to your trading strategy to maximise consistent returns.
How Does The 3-5-7 Rule Work?
The 3-5-7 rule is a simple, scalable risk management strategy that is ideal for traders who are just starting out, whilst also providing a foundation to build more tailored risk management strategies in the future.
At its core, it is made up of just three simple rules
No more than three per cent of your capital should be at risk during a single trade.
No more than five per cent of your total capital should be exposed to the market at any time.
Winning trades should make a seven per cent profit.
These are easy to follow, easy to measure and allow for quick responses and decisions to be made during particularly volatile periods in the market.
Why Does The 3-5-7 Rule Use These Specific Percentages?
Whilst part of the appeal of the 3-5-7 rule comes from how much we love those three numbers as the first three odd-numbered prime numbers and variations of the 3-5-7 pattern occur in other walks of life, there is a specific reason why each number is chosen.
Why Three Per Cent Risk?
A successful trading portfolio should be relatively conservative, as no individual trade nor string of bad luck should have the power to wipe you entirely.
However, given the costs of maintaining trading positions, a portfolio cannot be so conservative as to make profits impossible to obtain.
For example, if you have a trading capital of $100,000, you should avoid risking more than a $3000 loss on a single trade.
It causes you to focus on your position sizing and stop-loss orders, allowing you to get out quickly if the market turns rather than hoping for a turnaround that may never come.
Why Five Per Cent Exposure?
The five per cent part of the rule concerns exposed capital and how much you actively have at risk. As many positions can affect each other, this helps to minimise the losses you take and encourages diversification.
If the three per cent rule involves risk exposure over a single trade, the five per cent rule affects your whole portfolio, and stops you from taking a huge number of trades that could collectively wipe you out, even if each one is relatively safe from a risk management perspective.
It helps you see the bigger picture and adjust your portfolio if you do have more losses than gains.
Why Seven Per Cent Profit?
The seven per cent rule for profit margins reflects the market reality that a lot of trades will not necessarily be successful, but as long as your profits are large enough, they can wipe out your losses and then some.
You do not need to win every trade, something that is actively impossible. However, when you do succeed, you often do so in ways that help you claw your way back into profitability.
It also avoids being too cautious to make money; given fees and interest, a small enough gain can lose you money. Instead of exiting winning trades early, let them run long enough to maximise their earning potential.
How Do You Implement The 3-5-7 Rule In Your Trading Plan?
Assess your existing strategy.
Trade smaller positions than usual.
Set clear, disciplined stop-loss orders.
Keep a trading journal that assesses your position entries and exits.
Review your trades and how you react to gains and losses.
Consider scaling your risk when trades move in your favour.
Think about existing market conditions.
Adjust for volatility.