In prop trading, traders can use the capital of the sponsoring company in addition to their own capital. To protect their capital, they must adhere to some strict risk management regulations. One of the common and important rules is the max loss rule. So what is the max loss rule? How will this rule affect your trading strategy? Let’s find out more in this article.
What is max loss?
Max loss is a risk management rule that defines the maximum loss limit that a trader can incur in his account. When the loss exceeds this limit, the system will automatically terminate the trading privilege or block the account. For evaluation or sponsorship programs, violating the max loss means the trader will be disqualified from the process.
Controlling trading risk is the main goal of the max loss rule, which helps protect the account from the risk of significant losses. This rule forces traders to maintain self-control and refrain from impulsive decisions that can lead to “burning” the account. As a result, traders can maintain stability and survive in the market for a long time.
Why should proprietary traders understand the max loss rule?
The max loss rule not only benefits traders but also provides funding companies with a “safety fence” to protect their money. Traders are forced to maintain discipline, manage risk and control emotions when participating. This lays the foundation for their trading career to develop sustainably.
- Protects accounts from large risks: By limiting risk, the max loss rule helps traders prevent their accounts from disappearing after just a few consecutive losses. This limit forces traders to be more cautious when determining their trading volume, setting appropriate stop losses, and maintaining discipline. This is essential for maintaining long-term stability and protecting capital.
- Create a disciplined habit: Traders tend to plan ahead and stick to their strategies when they are aware of their limited losses. This helps them develop disciplined trading habits, minimize the negative impact of temporary emotions, and curb impulsive trading behavior. This discipline helps traders maintain long-term stability.
- Avoid emotional trading: Many traders easily fall into psychological traps when they are on a losing streak, such as trying to absorb losses or increasing trading volume to recover, which increases the risk. Applying the max loss rule is like a protective “shield”, reminding traders to stop at the right time. As a result, they avoid impulsive decisions and keep their accounts safer in the long run.
- Optimizing long-term performance: By adhering to strict risk management rules, traders can keep their accounts running for longer periods of time, rather than quickly being swept away from the market. They will gradually develop their trading abilities and build their own style with enough time to practice and gain experience.
Common types of max loss rules
The max loss rule is not always applied rigidly in practice, instead, it can be flexibly adjusted according to the policies of each brokerage firm. Each organization often builds its own set of rules to manage risks and protect assets. Specifically:
Max daily loss (Daily loss limit)
Max daily loss, also known as intraday loss limit, is an important rule that determines the maximum loss a trader is allowed to suffer in a trading session. When the loss reaches this level, the trader is forced to stop trading and is not allowed to open a new position until the next day. This rule helps limit losses that occur too quickly in a day due to emotions or bad decisions.
For example, the daily loss limit for a $100,000 trading account is $2,500. If your daily loss reaches this level, the system will automatically stop trading.
Maximum total loss
Maximum total loss, also known as total loss limit, is the maximum loss a trader can sustain while participating in the market. If the loss exceeds this amount, the account will be suspended and the trader will be removed from the evaluation/funding program. This is an important rule for long-term capital preservation and trading discipline.
For example, the maximum total loss for an account with a value of $50,000 is $5,000. If you violate this, your account will be permanently closed.
Trailing max loss
Trailing max loss is also known as the maximum trailing loss limit, in which the maximum loss is not fixed but changes depending on the fluctuations of the account balance. When the trader achieves profit, the allowable loss threshold is also adjusted to increase, which means preserving a part of the achieved profit. Thanks to that, this rule helps traders control risks while maintaining trading results.
For example, the max trailing loss is $90,000, and your initial capital is $100,000. The max trailing loss when the account reaches $105,000 would be $95,000. The rule will be broken if the account falls below this threshold.
How to calculate max loss in trading
You can use the equity ratio or a fixed amount specified by the proprietary trading firm to determine the max loss rule. There are two common ways to calculate the max loss:
Max loss as a percentage
This formula is usually based on a percentage of the account or a fixed number set by the company. This makes it easy for traders to determine their loss limits, allowing them to adjust their position sizes and improve risk management.
Max loss = Initial capital x Maximum loss rate
Example: Initial capital is 100,000 USD, while maximum loss rate is 10%
Max Loss = 100.000 × 10% = 10.000 USD
=>> This means the maximum amount you can lose is $10,000. You will be in violation of the rules if you exceed this limit.
Max loss by fixed amount
In some cases, the exchange or brokerage firm will provide a specific number instead of a percentage.
Max loss = Fixed amount (determined by the proprietary trading company).
Example: Account with capital of 50,000 USD with max loss rule of 2,500 USD
=>> This means you can only lose a maximum of $2,500 during the transaction.
How can traders avoid violating the max loss rule?
Traders must develop a strict money management strategy to avoid violating the max loss rule. Here are some practical methods:
Determine the risk on each order
The risk level that a trader should set for each trade is only 1% to 2% of the total account capital. With this strategy, you can endure a series of consecutive losing trades without seriously affecting the account. It also helps you avoid violating the max loss rule. Maintaining a stable mindset and long-term trading ability is also supported by careful risk allocation.
Set stop loss clearly
To minimize risk, you must set a precise stop loss every time you place an order. Trading without a stop loss is risky because even a small change can have a negative impact on your account. In addition to protecting your money, a stop loss helps you maintain discipline and resist the urge to lose control when the market moves in the opposite direction. This is a basic but extremely important principle for sustainable trading.
Split orders
Traders should spread their positions across multiple orders instead of investing all their money in a single large order. This method helps to better control risks and minimize psychological stress when the market is volatile. You can easily manage stop-loss orders, exit orders in segments, or adjust your trading method when there are many small orders. This is a safe way to protect your account and stay within the max loss rule.
Limit overtrading
Overtrading occurs when a trader places too many orders in a short period of time, often due to emotions or the desire to quickly recover capital. This is a common mistake that causes the account to lose money quickly, easily leading to a violation of the max loss rule. Traders must have a clear plan, only place orders when the conditions of the predetermined strategy are met, and be patient to avoid getting caught up in market volatility to prevent overtrading.
Continuous balance monitoring
To stay aware of your capital, traders must closely monitor your account balance and actual drawdown. By understanding the max loss rule, you can adjust your order volume and trading strategy in time. Ignoring this control factor can inadvertently cause your losses to exceed the allowable level. To ensure safe trading, it is extremely important to constantly check your balance and drawdown.
Keep your mind steady
Traders should proactively stop trading as soon as their account balance approaches the max loss rule. Emotions can easily take over during this period, especially the desire to ‘recoup’, which can lead to rash and dangerous decisions. In addition to preventing you from violating the max loss rule, pausing also gives you the opportunity to calmly review your approach, learn from past mistakes, and prepare for future trading opportunities.
Conclude
The max loss rule is not just a proprietary trading rule, it is a survival principle for a trader. It allows you to protect your account, maintain discipline, control your emotions to achieve success. If you are participating in proprietary trading programs or trading with your own capital, you should clearly define and strictly adhere to your loss limit. Trading success comes from the ability to manage risk sustainably over time, not from winning big on a few trades.