What Is the 3-5-7 Rule in Stocks?

The 3-5-7 rule is a risk management framework used by active traders to limit how much capital they put at risk on any single trade, across all open positions, and when to take profits. It did not come from a single book or a famous investor. It emerged from trading communities and prop desk culture, where blowing up an account is not a theoretical concern but something that happens to real people every week.

The rule is simple to state. It takes discipline to follow.

The Three Numbers and What They Mean

Each number targets a different layer of risk:

• 3% — Never risk more than 3% of your trading capital on a single trade
• 5% — Your total risk exposure across all open positions should not exceed 5% of your portfolio at any one time
• 7% — When a position gains 7%, consider taking profits or locking in gains with a trailing stop

Notice that the first two numbers are about limiting losses, and the third is about capturing gains. That asymmetry is intentional. Most traders are good at entering trades. Almost nobody is good at exiting them.

The Math Behind 3%: Account Survival

The 3% rule sounds conservative. It feels conservative when you are sitting on a trade you are sure about. But here is the math that makes it non-negotiable for anyone serious about trading long-term.

Assume you have a $10,000 portfolio. At 3% risk per trade, your maximum loss on any single position is $300.

Ten consecutive losing trades is not rare. Any trader who has been active for more than a year has probably had a string like that. At 3% per trade, you still have 73.7% of your capital intact after those ten losses. At 10% per trade, you have lost two-thirds of your account. At 20%, you are essentially starting over with a tenth of what you began with.

That is not bad luck. That is math. The 3% rule exists precisely because losing streaks are inevitable, and the goal is to still be in the game when they end.

Why 3% and Not 2% or 5%?

This is a fair question. The 1% rule (favored by some professional day traders) and the 2% rule (common in institutional trading) are both more conservative. The 3% level was chosen because it balances survival with the practical reality that many retail traders are working with smaller accounts where 1-2% limits make position sizing extremely difficult.

At $5,000, a 1% risk limit means you can only risk $50 per trade. That works if you are trading fractional shares of cheap stocks, but it becomes almost impossible to manage with commissions, spreads, and minimum position sizes on many instruments.

Three percent is the upper bound, not the target. Many experienced traders who follow the 3-5-7 rule actually risk 1-2% in practice. They use 3% as the absolute ceiling they will not cross, not the default setting.

The 5% Exposure Cap

This is the part of the rule that most traders ignore. The 5% cap on total open-position exposure means that even if you have five trades open simultaneously, the combined maximum loss if everything goes wrong cannot exceed 5% of your portfolio.

In practice, that means if you are running three open positions, each position can only risk about 1.7% of your total capital. Having multiple trades open does not give you more risk budget. It forces you to divide the same 5% pool across all of them.

The logic here is about correlation. In a market selloff, positions that look unrelated often move together. Technology stocks fall. Semiconductor stocks fall. Consumer discretionary falls. You might have thought you had three uncorrelated trades open, but if the S&P 500 drops 3% in a day, they all lose money at the same time. The 5% total cap is insurance against that scenario.

The 7% Profit Target: Taking What the Market Gives You

The third number is different in character from the first two. The 3% and 5% rules are about defense. The 7% rule is about offense, specifically about not letting a winning trade become a loser.

When a position reaches a 7% gain, the rule says to act. That does not necessarily mean selling the entire position. Many traders interpret this as the point to move a stop-loss to breakeven, sell half the position and let the rest run, or trail a stop to lock in a portion of the gain.

The 7% figure also creates a specific reward-to-risk ratio. If you risk 3% to make 7%, your reward-to-risk ratio is roughly 2.3:1. That is above the minimum 2:1 ratio that most professional traders require before entering a position. Even if you only win 40% of your trades, a 2.3:1 ratio keeps you profitable over time.

This is why traders who follow the 3-5-7 rule can be wrong more often than they are right and still come out ahead. The math works in their favor when losses are capped at 3% and wins are targeted at 7%.

How It Compares to the Kelly Criterion

The Kelly Criterion is a mathematical formula developed by John L. Kelly Jr. in 1956 that calculates the optimal percentage of capital to bet on each trade, given your historical win rate and reward-to-risk ratio.

For a trader with a 50% win rate and a 2:1 reward-to-risk ratio, the Kelly formula recommends betting 25% of your capital per trade. That sounds aggressive because it is. Full Kelly is widely considered too volatile for practical trading, since a string of losses will devastate an account even if your long-term edge is real.

Most serious traders use Half Kelly or Quarter Kelly, which in the above example would mean 12.5% or 6.25% per trade. The 3-5-7 rule is more conservative than even Quarter Kelly in most scenarios, which makes it more appropriate for traders who are still developing their edge and do not have years of data on their actual win rates.

The Kelly Criterion is mathematically optimal given accurate inputs. The 3-5-7 rule is practically robust given uncertain inputs. For most retail traders, the latter is more useful.

When the Rule Works Best and When to Adjust It

The 3-5-7 rule was designed for ranging or sideways markets, where false breakouts are common and trades often reverse before reaching large gains. In strong trending markets, capping profits at 7% can mean leaving significant money on the table.

During the 2020-2021 bull market, many stocks ran 30%, 50%, or 100% without a meaningful pullback. A trader who sold every position at 7% gain missed most of those moves. In those conditions, the right adjustment is to either use a trailing stop rather than a fixed 7% exit, or raise the profit target to 10-15% while keeping the 3% loss limit unchanged.

In choppy, uncertain markets (like 2022 or the periods around major Fed decisions), the original 3-5-7 parameters tend to perform well. Stocks often rally 5-10% before reversing, so taking profits near 7% captures a realistic chunk of the available move.

The rule should be treated as a baseline, not a law. What should never change is the underlying logic: losses must be small, total exposure must be capped, and profits must be taken before they evaporate.

Common Mistakes When Applying the Rule

The most frequent error is moving stop-losses once a trade goes against you. A trader sets a stop at 3% below entry, the stock drops to that level, and rather than taking the loss, they move the stop down another 3%. This destroys the entire mathematical foundation of the rule.

A related mistake is counting paper losses differently from realized losses. Some traders think, "I am only down 3% on paper, I will hold through it." But a 3% loss is a 3% loss whether you close the trade or not. The rule applies to your position size at entry, not to what you are willing to absorb emotionally.

Another common error is failing to account for the 5% total exposure cap when adding new positions. A trader with two open trades (each risking 2.5%) has already used their full 5% budget. Opening a third trade means they are either exceeding the cap or need to reduce the size of one of the existing positions.

The 3-5-7 Rule vs. Other Risk Rules

The 1% and 2% rules are widely used in professional settings but do not include a profit-taking component or total exposure cap. They address one dimension of risk (per-trade loss limits) without addressing position aggregation or exit strategy.

The 3-5-7 rule is more complete as a system, even if the specific numbers are somewhat arbitrary. A trader who internalizes all three components has answered three questions that most beginners never ask: how much do I risk per trade, how much am I exposed to simultaneously, and when do I actually take profits.

Frequently Asked Questions

Does the 3-5-7 rule apply to long-term investors?

Not really. This rule was designed for active traders who enter and exit positions frequently. If you are a buy-and-hold index fund investor, the relevant risk framework is your asset allocation (how much in stocks vs. bonds), not per-trade risk percentages. Selling your VOO position every time it gains 7% would be a terrible strategy for someone trying to grow wealth over 30 years.

What does "risking 3%" actually mean in practice?

It means the distance between your entry price and your stop-loss price, multiplied by your position size, equals no more than 3% of your total portfolio. If you have $10,000 and buy a stock at $50 with a stop at $48.50 (3% below entry), you can buy up to 200 shares ($300 / $1.50 per share). Your dollar risk is $300, which is exactly 3% of $10,000.

Can I use the 3-5-7 rule with options?

Yes, but options require extra care because they can go to zero. Many options traders treat the premium paid as the total risk, which makes the 3% rule easy to apply: just do not spend more than 3% of your portfolio on any single options trade. The challenge is that options can lose value very quickly, so the 5% total exposure cap becomes even more important.

What happens if my win rate is below 50%?

A win rate below 50% is fine as long as your winners are larger than your losers. With the 3-5-7 rule's built-in 2.3:1 reward-to-risk ratio, you need a win rate of only about 31% to break even. Anything above that is theoretically profitable. Most decent traders hit 40-55%, which gives a meaningful edge over time at these ratios.