Trading - Money Management

Trading - Money Management

In a previous article I explained that one factor making it more difficult to trade a small account for capital growth, as opposed to a larger account for revenue, is that you are obliged to take on more risk.

Every trade I place has a logically determined stop loss level. This level defines the theoretical trade risk.

While a trader with a large account will be able to enter the trade risking less than 1.5% of his or her trading capital, the small trader may well need to risk a much higher percentage, or pass on the trade.

However, there is another more subtle problem that compounds the difficulties faced by an under-capitalized trader. This is illustrated in the following example. (I trade grain markets, where one point is worth $50. The popular S&P 500 emini contract has the same structure.)

Suppose we take two trades in succession. In each trade, our risk is 2 points ($100) and profit potential is 5 points ($250). The first trade wins and the second trade loses. Consider how this impacts a small account of $6.5K, and a larger account of $35K, assuming for this example that we are prepared to risk 3% of our capital on any one trade.

Small Account

First Trade: Amount we can risk = 3% x 6,500 = $195. Dividing by the estimated trade risk ($100) shows we can trade 1 contract. The trade wins $250, increasing capital to $6750 (ignoring trading costs).

Second Trade: Amount we can risk = 3% x 6,750 = $202.50. Dividing by the estimated trade risk ($100) shows we can now trade 2 contracts. The trade loses $100 per contract, reducing capital to $6550 (ignoring trading costs).

The two trades net just $50. In real trading, we would do well to break even.


Large Account

First Trade: Amount we can risk = 3% x 35,000 = $1,050. Dividing by the estimated trade risk ($100) shows we can trade 10 contracts.* The trade wins $250 per contract, increasing capital to $37,500.

Second Trade: Amount we can risk = 3% x 37,500 = $1,125. Dividing by the estimated trade risk ($100) shows we can now trade 11 contracts. The trade loses $100 per contract, reducing capital to $36,400. The two trades net a very respectable $1,400, less costs.

• In practice, there may be insufficient capital to trade 10 contracts, depending on the margin levels set by your broker.
  

What Happened?

In both accounts we took two identical trades, one winner and one loser. The winner won more than twice as much as the loser. This produced a nice gain for the large account, but virtually no gain at all in the small account.

The problem occurs when the first win increases capital to the extent that more contracts can be taken on the next trade. With the small account, we move from 1 contract to 2, with the large account we go from 10 contracts to 11.

The small account increases the number of contracts traded by 100%! When the next trade loses, the loss is nearly as large as the previous win, and profit is negligible.

With the larger account, the number of contracts increases by just 10%, so the impact of the subsequent loser is much smaller. The greater the number of contracts you are trading, the less impact the asymmetric effect has on your results. Somebody trading the grains with a $100K account, using a 1.5% risk factor, would barely notice it.

There are various strategies you can adopt to try and minimize this effect, but the bottom line is that a small trader will always face a difficult hump to get over at the points where their money management plan dictates an increase in the number of contracts traded.

You can follow daily real life trading results for the "small account - capital growth project" in the trading diary on my web site.