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Risk Management, Trader education

Account Undercapitalization is the Primary Cause For Trader Failures

About 11 years ago, I gave a presentation in a conference in New York City as an invited speaker. The audience was mostly comprised of inexperienced traders. A good part of my presentation was on the subject of risk of ruin and proper account capitalization.

After I explained what consecutive losers are, how they contribute to drawdown and that getting 4, 5 or even 7 consecutive losers is normal in trading, I wrote down this simple formula that determines proper account capitalization:

Trading account minimum capital = Amount risked per trade / Percent risk

The amount risked per trade is usually determined by the stops. The percent risk determines what percentage of the account is risked on each trade. For example, if a swing trader of ES futures risks $500 on each trade and each time only 2% of the account should be at risk, then the required trading account equity is equal to $500/0.02 or $25,000.

Let us assume now that the trader starts with $5,000 in the account. The trader knows that this is a small amount to start with and an attempt is made to make the stops as tight as possible without affecting a lot the profitability of the trading method. The improved trading method risks only $350 on each trade instead of $500. After rearranging the above equation  we get

Risk percent = Amount risked per trade/Trading account equity

In the case of the new example with the improved stop, the risk percent turns out to be $350/$5,000 = 0.07 or 7%. This means that 7% of the account is risked on each trade. Does this sound like a lot?

It sounds like way too much to experienced traders but often too little to newcomers or gamblers. This is because inexperienced traders always hope for a good streak of winning trades first to act as a cushion before a drawdown arrives. This happens rarely experience (and math) says and a drawdown arrives first. With 7% risked on each trade a 5K account will be reduced to $3478 after 5 consecutive losers and to roughly 3K after 7 consecutive losers. If the trader cannot cover the margin requirement then any open positions will be liquidated. Reducing the probability of ruin requires a smaller risk percent, like 2% for example, and in that case the proper account equity size is determined by the original formula and it is equal to $350/0.02 or $17,500. The difference in the two accounts is a respectable 250% or in other words, the trader with the 5K account is undercapitalized by a factor of 2.50.

These are some of the facts I tried to explain 11 years ago with many more examples and details that included determination of account size for futures trading systems and taking into consideration drawdown estimates. (More information can be found in one of the books I have authored, which are all out of print by the way). Shortly after I finished my presentation, someone from the organizers approached me and told me that a group of individuals rushed to her office and complained that I was discouraging them from getting involved with trading because none of them had more than 5K to start with and they got scared after they attended my presentation. That did not come as a surprise to me. I expected that type of a reaction.

What happened during that interesting period of the markets, which included a rally of the Dow Jones to all-time highs, the dot-com boom and the bear market that followed, is that many traders after failing a few times to make it in swing or position trading due to their low capitalization, they entered the day trading arena. They either figured it out themselves or were directed there by those who realized that the only way to keep the capitalization requirements low and at the same time avoid the risk of ruin was to lower the amount risked per trade down to a few ticks. Thus, when the ES futures started trading most day traders risked a few ticks per trade, like ann equivalent of $5o to $100. Some even tried and are still trying, 1 tick stops, or $12.5. That certainly lowers the capitalization requirements. For example, for a 4 tick stop, or $50, and 4% risk per trade the required account equity is just $1,250. What is the catch?

The catch goes by the name volatility.  At that level of trading there is a lot of noise, or random walk, generated by all the market participants. This neutralizes any small trading edges after a while because of the commission effect. If commission paid is about 10% of the average winner for scalpers (traders who chase a few ticks), for example, and the winning edge is only 5%, or 55% winners, then it is very hard to make money. The only way out is by increasing the edge substantially, or decreasing the risk to reward ratio, something that we all know is very hard to do in those timeframes. Thus, the majority of scalpers are doomed. Only those with a substantial edge and low risk to reward ratio survive.

Then, there is the issue of HFT in the equity markets. In those markets, the flood of ambitious, poorly capitalized traders was dealt with fast order placing that essentially creates an additional commission effect by front-running orders and thus increasing the demand for even larger winning edges to levels beyond what is achievable. Scalping the equity markets is considered dead at this point and most active traders have increased their timeframes to beyond 5 minutes, some to 30-minute intervals or to even longer.

Proper trading account capitalization is very important but it cannot help those with an edge smaller than the commission wealth-out effect on their account. Update (04/23/2011): this is a post with specific examples of the impact of commission rate on profitability coupled with account capitalization. It shows that depending on starting capital and commission rate, risk of ruin is possible regardless of the presence of an edge. Update (11/03/2013): this post shows how forex daily and intraday trading turn into a negative-sum game as soon as spread and slippage are introduced.

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