What is the 3-5-7 Trading Rule?

How one trades differs from person to person. However, traders will by and large rely on strategies and rules to come to trading decisions. One of these is the 3-5-7 trading rule, which seeks to help traders manage risk and set profit targets. More specifically:

• 3%: risk management (maximum risk per trade)
• 5%: maximum exposure across all trades (based on the timing of the transaction)
• 7%: profit target or minimum profit-to-loss ratio

The 3% rule: managing risk and capital

As the title would imply, the rule is that an investor risks no more than 3% of their total capital on a single trade.

The idea is to avoid one significant loss from severely impacting a trader’s overall portfolio and depleting all their capital.

So how would this look in practice?

Well, if an investor has an account balance of $1k, acting on the premise of the 3% rule, they would not risk more than $30 on any individual trade.

In this way, if for some reason the market moves in an adverse direction, the trader’s loss should not exceed $30 before exiting the position.

How is the 3% trading rule implemented?

The trader will likely set stop-loss to automatically exit a transaction if the loss reaches the predefined level.

To set the limit, the investor should first consider their total account size and then calculate 3% of that sum.

This ensures peace of mind and removes the emotional element of entering or exiting a trade.

The 5% rule: timing or exposure

In trading, there are two versions of the 5% rule.

1. Timing of trades

In this context, the 5% rule focuses on the timing of a trade in order to leverage the potential for profit. In essence, by following this rule, an investor will wait for an asset’s price to move up or fall by 5% from a predefined price level before entering a trade.

The idea behind this is that a 5% shift effectively confirms the asset’s trend, suggesting that the price is likely to continue moving in that direction.

What would this look like in live trading?

Let’s assume the trader’s preferred asset is a commodity, like gold. If gold is currently priced at $1,800 per ounce, the trader may want to wait until it reaches $1,890 for a bullish trade (if they plan to buy) or $1,710 for a bearish trade (if they intend to go short).

This 5% movement signals that the commodity, in this case gold, has gained enough momentum to justify executing the position.

2. Portfolio diversification and exposure

In this context, the 5% rule refers to the guideline of limiting your total exposure to 5% of your total capital across all open positions. This principle is based on portfolio diversification, helping to reduce risk by spreading your capital across a variety of assets or asset classes.

Broader exposure can also reduce the impact of volatility in any single market as well as help you profit from a variety of market conditions.

The 7% trading rule: profit-to-loss ratio

The goal of the 7% rule is to achieve at least 7% more profit on winning trades compared to losing ones. In this way, traders somewhat protect themselves from unavoidable minor losses.

This approach ensures that successful transactions contribute more significantly to overall profitability.

Furthermore, by targeting a 7% profit on winning transactions encourages traders to pursue those transactions with a more balanced risk-to-reward ratio, increasing the potential for more consistent profitability in the long term.

Interestingly, the 7% profit target also has an impact on trading psychology. It instills focus and displine, reducing the influence of emotions like greed or arrogance on trading decisions.

It also minimises the temptation to hold onto a transaction for longer than necessary, and makes it easier to measure the performance of their strategy over time.

What is the appeal of the 3-5-7 approach to trading?

For several reasons, traders choose to follow the 3-5-7 trading rule when investing.

For one, by limiting the risk per transaction to 3%, traders can mitigate the types of losses that can completely drain one’s capital.

Secondly, waiting for a 5% price movement allows traders to time their entries more strategically.

This may potentially improve their chances of capturing profitable market shifts. The 7% profit target can also help traders achieve profits potentially more consistently, allowing for more predictable account growth.

The rule is also incredibly easy to understand and implement, making it a attractive choice for both beginner y advanced trades.

Signing up for a demo trading account

One of the best ways to learn how to apply the 3-5-7 trading rule is by signing up for a demo account and practicing in real market conditions without risking real money.

This allows traders to experiment with the rule, tweak their investing plan, and gain critical confidence before moving to live trading.

A demo account will also give you access to the MetaTrader 4 platform, giving you the perfect opportunity to learn how to navigate the system. You can gain experience on análisis técnico, a very important component of investing and the basis for entering and exiting positions.

You can also assess trading outcomes and then make changes to your strategy as and when necessary. Having the time to acquire more skills and experience without putting your own capital at risk is likely going to help you gain the confidence you need to move to real-life trading.

3-5-7 trading rule and risk management

We’ve already established that risk management tools must be utilised in the application of the 3-5-7 rule to trading.

In summary, the measures to take are as follows:

1. Position sizing (tamaño de la posición). Establish the amount of capital you have available to you for the purposes of investing without putting essential savings at risk, and then apportion according to the percentages.
2. Órdenes stop-loss. Ensure these are set to limit unanticipated losses. Some of the most popular types of stop-loss orders that are utilised are hard stop-loss and trailing stops.
3. Diversificación de cartera. This technique seeks to reduce the impact of a losing position on one’s overall portfolio, protecting your money in erratic or volatile markets.
4. Avoid overtrading. This occurs when a trader enters into too many positions, or frequently opens and closes transactions without merit.
5. Utilice análisis técnico. Avoid emotional trading and instead make use of technical indicators to confirm entry and exit points. This will also help filter out false signals.
6. Mantenga un diario de trading. While this rule certainly helps maintain discipline, consistency and focus, it cannot eliminate the impact of feelings on trading outcomes. By keeping a journal, you not only record the transactions you executed and how they performed. You also record the rationale behind each transaction, the behavior the transaction triggered, and the outcome. In this way, you can start identifying patterns in your decision-making process and start making necessary adjustments not only to your strategy but to the way triggers make you act.
7. Engage in some form of learning. Whilst not a risk management tool per se, keeping yourself up to date with market trends and advancements is key to maintaining your expertise. Utilise resources like blogs, e-books, videos, seminars, webinars, podcasts, etc, to acquire information, insights, concepts, and tips. Consider joining an online community of traders where you can engage with other traders to share ideas and strategies.

Use trading rule 3-5-7 with IronFX

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You’ll also be able to enjoy fast withdrawals and deposits, and market access via the MetaTrader 4 (MT4) trading platform, arguably one of the world’s most popular trading systems amongst global traders.

The IronFX Academy also offers an abundant source of educational resources to boost one’s skills and acquire fundamental trading insights.

Disclaimer: This information is not considered investment advice or an investment recommendation, but instead a marketing communication. IronFX is not responsible for any data or information provided by third parties referenced, or hyperlinked, in this communication.