Saturday, May 17, 2014

Thoughts on starting out with a small capital base

There is an old saying that "if you want to make a small fortune from trading, start with a large one!". Occasionally I get asked "What is the minimum amount of money I need to trade?". 

 
The short answer was given by Ed Seykota: "Good money management is equity invariant. I'd ask a trader who thinks he needs a certain before he can trade exactly what amount he would need to stop trading." Despite what Seykota says, there are some capital base considerations that should be thought about before starting out.

For what its worth, these are my own thoughts on starting out on your trading journey, based on my own experience and of those traders I have met and/or mentored over the last few years.

Most new traders have their priorities in the wrong order. They focus on entries and exits, with risk management and working on themselves and their mindset mere afterthoughts. You will save yourself a lot of pain, time and money if you reverse your priorities.

Risk management and psychology are closely intertwined. If you have good risk control, then it becomes much easier to stick to your system rules. Your stress levels will be lower.  You will lower the risk of self-sabotage. You will attain an 'emotional indifference' towards each trade.

Most new traders have a rose-tinted view that all they need is an internet connection and a few hundred pounds, and off they go. What's so difficult about it? They've been sold the vision that you can take thousands out of the market regularly, if not on a daily basis. The reality is quite different. Trading is hard work. You need to put in a lot of groundwork before you can be consistently successful. Some people do not want to go through that. They want success - now. Invariably, this means that risk management is not even a consideration. All they can see is profits, not losses.

What can make it worse is if a trader gets lucky and has a big winner early on. Anyone can get lucky on a single trade. Good traders look in terms of the next 1,000, or 10,000 trades. They know they can suffer a run of losses, price shocks etc.
 
Paper trading may give a new trader confidence in that a particular approach may work, but without having real money on the line, the trader will not experience the gamut of emotions that you can feel (hope, fear, greed etc). Putting up your own hard-earned cash immediately brings these elements into play. How you react to the vagaries of the market, combined with your risk approach will ultimately determine whether you can achieve long-term success.

People believe that they are right, and that the markets are wrong. It is the other way round.You need to park your thoughts or opinions at the door. Any price move will determine whether you are making money or losing money. The fact that price may move contrary to your own thoughts or opinions is irrelevant.

Even though you may only have a small capital base, it is imperative that you implement proper risk controls as soon as possible - ideally from day one. Most traders risk no more than 1%-2% of their equity on a trade. Some conservative traders I know risk only 0.5% of their equity per trade.

Your capital base may determine what markets and the style of trading you can participate in. For example, if day trading US stocks you require a minimum equity level of $25,000. If trading futures contracts you will need significantly more.

Conversely, if you are based in the UK you can use spreadbetting as a method to start trading. Traders in other parts of the world can trade using CFD's. These are both leveraged products, which can help those starting with small amounts of equity, BUT it forces those traders to be extremely rigorous in their risk management. You can lose more than you anticipated.

With products such as these, your provider may offer guaranteed stops or controlled risk on certain stocks or instruments. These can limit your losses if, for example, a stock gaps down through your intended stop level. There is a small premium to pay, and there are limiting factors to be considered in using them, but they can provide peace of mind when using small levels of capital. As you progress as a trader, and your equity level increases, then using guaranteed stops can become more difficult to use effectively. But by that time, good risk control should be embedded within you and you can do away with using them.

People with large amounts of starting equity do not necessarily feel the pain of losing money when a trade goes against them. If they have that much disposable income to begin with, then there can be a higher probability that their risk control won't be as strong. More than one successful trader has said that they would have more confidence in someone starting out with a few thousand dollars, than someone starting out with a million bucks.

In a perverse way, I think someone who has struggled initially at the beginning, but has survived because of good risk control and by developing their mindset ends up having far greater chance of success. See here for an example.

In an ideal world, you want to be the worst trader right at the start of your journey, when your equity is at its smallest. Therefore, any mistakes in pure monetary terms are kept as small as possible.

For inspiration, you can read books like Market Wizards - Richard Dennis started out with only a few hundred dollars. There are plenty of other traders out there like that. Some successful traders initially struggled and blew up an account or two before hitting their stride. Some started marking money virtually from day one.

To summarise, there is a lot to be said for starting out trading with as small a capital base as possible. But I would strongly suggest going through the following checklist or some similar process as a starting point:
  • Conduct some initial studies into what sort of style of trading you feel makes logical sense to you, that you feel comfortable with and want to employ;
  • Ascertain whether you will be able to trade in this chosen style around your existing work or family commitments (i.e. if you have a full-time job it would be tricky to day trade);
  • If you can, look to see what sort of vehicles you can use to trade in this manner (i.e. spreadbetting, CFD's, options etc) and see if there are any minimum capital requirements;
  • Read up on your chosen style and start to formulate an action plan (what to trade, when to trade, how to identify entries, exits and stops);
  • Most importantly, set down some risk parameters, factoring in things such as slippage or gaps through intended stop levels;
  • Start trading;
  • Record all your results, and review on a regular basis.
One other tip, that a trader friend of mine recently gave me. In addition to simply recording trade entries/exits, and the purely statistical side of his performance, he started keeping notes in a little book tracking his thought processes and emotions from one day to the next. He found this a huge help to him and also confirmed to him that, with one or two minor tweaks, the method of trading he was using suited his personality.

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