Trading a Small Account

Futures traders are wisely advised to trade with money they can afford to lose. That is because most beginning futures traders DO lose money. So, even if your dream is to use your life savings as capital to support your new occupation as a trader, you should curb your impatience and start with a small account while you learn the ropes. If you can make money with a small account, then by all means commit more funds later…

A better approach is to leave your life savings alone and plan your move into trading over a period of time, preferably while you have regular income from a conventional job. Again, it is a good idea to start with a small account while you learn about your new business. Your objective should be to grow the small account into a substantial nest egg which will form your trading capital when you retire or resign to become a full time trader. That way you will be trading your profits, not your life savings.

Having said that, trading a small account has a number of difficulties avoided with larger accounts. Before I discuss what these are, I need to digress for a moment.

Any experienced trader knows the importance of having a trading plan and sticking to it. "Plan your trade, and trade your plan" should be your motto. Without a plan you have no reference points during a trading session, you have no feeling of what to look for and what to do if you find it. Unless you turn out to be a freakishly talented intuitive trader, you will not be long for the trading world if you try to trade without a good plan.

The idea of the plan is to identify the setups which tell you when to trade, how large a position to take, where to place stops and targets, and when to exit the trade. Armed with the set of rules established in your plan, you are ready to set out on a voyage into the turbulent waters of the commodities markets. At least you now know how to react when the market throws different situations at you, as it invariably will.

There are some important numbers to know about any trading plan. They are the probability of a win, the probability of a loss, the average win size (dollars), and the average loss.

No setup is infallible, so inevitably some trades will lose. If you take 100 trades using a particular setup, and 60 of them win and 40 lose, the probability of a win is 60% and the probability of a loss is 40%.

If, for the same 100 trades, the average win is $200 and the average loss is $300, we have enough information to work out the likely effectiveness of the plan.

You can calculate the "Expectancy" of the plan, which is the average dollar amount you expect to make per trade before trading costs, by multiplying the average win by the probability of a win and subtracting the average loss multiplied by the probability of a loss. Unless this is a nice big positive number, your plan is no good.

In the example above, (60% x 200) – (40% x 300) = 0. In other words, over a long period this plan makes an average of nothing per trade, and will lose money because of trading costs. You would be amazed how many beginning traders use plans like this!

Most viable trading plans stress either a high win rate, or a high average win to loss ratio. Unfortunately, it is almost impossible to increase both these variables at the same time. Increasing the average win rate almost invariably forces a decline in the average win to loss ratio, and vice versa. This is the dilemma faced by all system designers.

Many of the most successful trading plans have a very high average win to loss ratio. For example, suppose the average win is $1000 and the average loss is $100 per trade. The average win to loss ratio is 10:1. If this plan wins just 20% of the time its expectancy is (1000 x 20%) – (100 x 80%) = 120 which is quite acceptable. This plan only wins one of every five trades taken, but will win over time because the winning trades are so much bigger than the losers.

By the way, many new traders seem to think that a 20% probability of winning means the market will consistently deal out trades like this: LLLLWLLLLWLLLLWLLLLWLLLLW where L = "Loss" and W = "Win". However, it is equally likely to deliver this ratio like this: LLLLLLLLLLLLLLLWLWLWLWLWL. That string of fifteen straight losses should give you pause for concern…

Earlier I mentioned that beginning traders with small capital accounts face higher hurdles than those faced by traders of larger accounts. The main issues the small trader faces are:

  1. Plans relying on a high win to loss ratio are generally unsuitable – for two reasons. (i) Beginner traders are seldom psychologically prepared to trade through a long run of losses which is characteristic of this kind of plan, and (ii) the account can be quickly reduced to an non-tradeable size by a string of losses before some good wins come in. That leaves little option but to look for a plan with a high win rate. (Traders with larger accounts can comfortably ride out long strings of losses and are therefore free to choose plans with a high win to loss ratio.)
  2. Small traders are inevitably targeting smaller profits per trade than their better capitalized counterparts. This brings fixed trading costs into the equation. Say your average trading cost is $30 per trade (brokerage plus "slippage"). if your trade target is $1000, then trading costs are 3% of targeted profits. But if your trade target is just $100, then trading cost represent a whopping 30% of the intended profit.
  3. Most plans use a money management technique designed to take advantage of leverage by trading more contracts as capital increases. There is something called the "asymmetric effect" at the boundary where the number of contracts increase. Suppose the trader with a small account has a good run trading just one contract, and now has enough capital to trade two contracts. The next trade is a loser, and because it is using two contracts, the loss may be considerably larger than the previous win(s). (The same thing happens to traders with larger accounts, but when moving from, say, six to seven contracts, the effect is much diluted.)

It is best not to get too mathematical about all this. The bottom line is that the small trader should go for a plan which wins smaller amounts consistently, while making stringent efforts to control trading costs. (I just started a project aimed at growing a small trading account into a decent sized nest egg. You can view live daily trading results here.

There is some comfort in all this. If you overcome these additional hurdles and make money with your small account, you will have developed the level of skill that should enable you to embark on a trading career with a high degree of confidence!

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