Wednesday, June 10, 2009

Capitalization and the Economics of Trading Success

If you follow the logic of the recent post on managing risk, you'll see why adequate capitalization is a core requirement for those who aspire to make a living from their trading.

No one would think of starting a restaurant, bed and breakfast, or beauty salon business with $20,000 in startup capital, but such a step is not so unusual for traders.

To be sure, a small account can be quite adequate for the initial learning of markets. There is much to be said for making mistakes while you're trading small, limiting the risks associated with a steep learning curve.

To make a living from trading, however, requires significant capital. An account size of $250,000 sounds large to many independent traders, but a return of 20% on capital (a very respectable performance for a year), minus the expenses of equipment, commissions, etc. turns out to be a pretty modest sum for a breadwinner.

When traders start their "business" with very small sums--under, say, $100,000--that 20% return would barely keep a family of four above the poverty line. Cognizant of these limitations, small traders try to make their living by shooting for very large and unsustainable returns. Gunning for 50+% per year, they inevitably take hits of half that or more simply as a function of normal slumps and the odds of encountering a number of consecutive down periods.

Many new businesses fail because of undercapitalization; many traders fail for the same reason. Even quite a few proprietary trading firms are not immune to this problem: they allow traders to trade large size until the trader hits a rocky patch and loses more than the firm can tolerate.

Look at it this way: if you can produce consistent 20% annual returns on capital with modest downside risk, you will always have a job as a portfolio manager for a top hedge fund. If you, as a beginning trader, rely on a business plan that calls for more than that, you are probably unrealistic in your assumptions and overly aggressive in your risk.

The simple truth that is so infrequently spoken is that those who trade for a living invariably already have access to significant capital. Nothing is more important for aspiring but financially limited developing traders than to build a track record of superior returns and risk management that will attract the interest of those with capital (such as prop firms). You will make your living by earning realistic returns on significant capital; not by sustaining monster returns on a small capital base.
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15 comments:

Dean said...

An interesting topic.

Do you think there is a difference in capital requirements between stock vs. futures traders? For example, in trading something like the ES, a few points a day on 2-3 contract lots would make a tidy living for someone capable of achieving this result (assuming such results are possible of course), all with a much lower initial capital requirement.

Also, it seems that there would be a difference between what is achievable as a large trader vs a smaller more nimble trader - ie. that a smaller trader could do 20%+ per year, but wouldn't be able to do that as a fund manager because the difference in trade size necessitates a change in strategy.

Brian said...

I had a similar question to Dean. If you had a daily goal of $400/day to sustain a living. Trading 4 contracts on the ES, that's 2pts per contract. With proper training and patience, that seems achievable.

Now if you have $50,000 or $250,000 in the account, the % gains for the year are vastly different but the fact is you are risking a paltry amount of your capital per trade regardless of the amount.

What am I missing? It seems from multiple statements in your books that your definition of trading success is making millions a year...what about those just looking to make a passable living? And why the continuous assumption that everyone is striving to get picked up by a prop firm?

Vlad said...

On the other hand, those who have $250,000 to start trading with, either

a) very successful in what they do and thus belong to category of traders who fail more on average trader, i.e doctors, business owners, etc, as they are used to achieving success via methods which will get you destroyed in the markets

b) got that money without ever working a day with for it , and thus lack discipline which is another sure way to disaster in trading

Amount of money deposited into trading account has little to do with person being able to conquer 95% of trading - human psychology

Any new trader has 92% chance of blowing up his/her account and most successful traders blew up 2-4 accounts before getting there.. any new trader has to realize that when entering the markets.... if you do have $250k of risk capital, you might as well keep doing what you are doing since your are obviously good at it :), odds are not in your favor anyway

Watson said...

Nice post. Many young traders are usually under capitalized if they are trading for themselves, and many do not have the confidence or experience to trade with amounts over $150,000 in my opinion, unless they work at a firm.

I guess it depends on what the goals are for trading. if their goal is to trade for a living, you are absolutely right. If their goal is to make some passive income, they might be able to do it with a smaller amount.

statistically most investors or traders will not beat the market anyways so they should recognize and adjust their trading strategies for their goals and lifestyle

Paul said...

Well I happen to not agree with you on this one. What you are actually saying is that one have to be relatively rich before start trading. 100 k is already a pretty large amount of money and 70% of globe population do not own that amount. I also taught at the begining of my career as a trader that 20%/ year would be enough but then changed my mind because why consuming energy and trading (actually investing if you aim for 20%) when one can put that money in a fund and do other things instead.
Trading is really very different from investing and really those few that succed are achieving much much more than 20%/year, think about this, lets say that 90% of wanna be traders lose money..where do you think that money go?...in the pokets of other 10%. Of course trading and investing are very different and maybe from a investor point of view 20-25% is a target but for a trader its really not worth wasting time. Trading is about excellence and those who succed are very few but they are rewarded like in no business on this planet. There is much more to say on this subject, if one aims for 20% he or she should really get a job and quit trding because the income will be pretty much the same and with a job would be less stressful, instead if one already has 1000k then he should really invest in a fund or leave them in a bank and live his life cause life is short :)). Sorry for my english its not my native language.

Michelle B said...

Though there are several views of yours that through the years I have come over to your side, this point of yours which you bring up here and there is something I still disagree with you strongly.

As far as I can conclude, you are a day trader yourself, though a part time one. For day traders who trade stocks on American exchanges, the large percentage of small account traders trading for their own account need at least $30,000 ($20,000 would be useless) in order to have unlimited day trades (otherwise it is just 3 trades allowed within a 5 trading day period). Such day trading equity allows for 4X leverage which would come to around $120,000. If you trade liquid ETFs, the chances are that you will always be able to close your positions within the day (ETFs, unlike stocks, most likely will not be halted because if you can't get out of your margined trade than you run the risk of having the margined account become a useless cash one due to the regulations/rules).

It is very possible to do about 3-5 trades daily, catching a .20 move (with .05 stop loss) in a day, netting easily about $500 daily. Full time day traders with relatively small accounts do not not focus on percentage of annual returns based on their non-leveraged cash base, but on the coin they mint daily/weekly/monthly. It is absurd to do otherwise.

And the aspect which you focus on in terms of needing a large capital base and NOT trading big because of the risk makes no sense whatsoever. What is it then? Small value trades which do not need mucho capital or mucho capital with small value trades (which makes no sense for a nimble, experienced day trader).

However, if one is going to give up the day job to day trade full time, then having enough to capital to pay living expenses while confronting the steep learning curve is the edge you should be emphasizing. But the actual capital base for an experienced, successful day trader who trades for her own account need not be much more than $30,000.

markus said...

As probably expected this post results in quite some contoversial comments.
Great post, anyway, and I can only agree with what your write, Dr. Steenbarger. The reason whoy a lot of start-ups fail in an early phase is a lack of capital (and linked with it a thorough financial planning). And in trading it may be much more the case, perhaps because a lot of people dream the get-rich-quick-scheme.
Before I started trading for a living, I made sure I could survive 2-3 years without any profit plus a trading account which is at least 4 times my costs of living. That was my rough formula and it helped.
By the way, why should it be harder to make consistent high percentage gains investing than trading. Every investment is just a trade, but trading generates on average more costs, therefore it should be the other way round.

Cheers,
Markus

Brian said...

Markus,

you wrote:
"The reason why a lot of start-ups fail in an early phase is a lack of capital"

No, the #1, #2 and #3 reason startups fail is they have a lousy idea.

Anyway, its a shame the good Dr. no longer has time to respond in the comments. I would love to hear his thoughts on what people have written here.

market folly said...

Excellent topic and post. I liken it to poker. This is just one of the many similarities between trading and playing texas hold 'em.

In playing cash poker games, you have to be adequately capitalized in an effort to a) have sustainability and b) go through the necessary actions of betting (or in this case, trading) and putting that capital at risk.

With a smaller bankroll, you're often forced to do things you might not wish to do.. you can get caught. One could also argue though that you would be more patient and wait for the best setups since you only have limited resources. The same could be applied to a big bankroll or 'stack' in poker... you can afford to try some plays willynilly because you have the cash to do so.

In the end, it's all about a safety net and cushion. I've been trying to come up with a post comparing poker and trading for some time now, but it never comes out right written down, shame. I'll keep trying though haha.

Good stuff.

Jay
marketfolly.com

Zen said...

Brian,

Actually most startups do not fail from lousy ideas. It usually is due to undercapitalization and then the inability to manage growth.

The major hurdle for startup businesses is that being good at something and being good at managing a business that does something one is good at are radically different skill sets, yet most do not recognize that.

At any rate... off topic :)

Dr. Brett I do agree with you here on this post, but I also recognize there are exceptions to the rule. A good leveraged trader doesn't necessarily need $250K.

Futures Trader said...

This is the age old question. How much capital do you need to trade for a living? Granted the more capital you have to start with the longer you will last if you are losing. However that just means that you will ultimately lose more money. If just starting out I think the key is to have enough that you can last long enough to learn what it takes to become a consistent winner. And the fact of the matter is that most people don't.

That being said I think you make an excellent point in the first part of your post when you said: "To be sure, a small account can be quite adequate for the initial learning of markets. There is much to be said for making mistakes while you're trading small, limiting the risks associated with a steep learning curve." If I was just starting out again today and knew nothing of the business instead of focusing on how much capital I needed in my trading account I would focus on having two years of all my living expenses taken care of. Then before ever risking a penny I would work on the simulator until I was making consistent gains. (When on the sim you must make it as realistic as possible – same risk, same contract size, etc as you plan to trade live). Then once I was making consistent gains on the sim I would go live with a VERY small account – say 5K and attempt to do the exact same thing I did on the sim. Of course this wouldn’t work and I would end up losing the entire 5K because we know that the sim and trading live are two very different psychological beasts even when trying to treat the sim as if it is live. Once I could get through a month of trading live with my 5K account intact it would be time increase the account size and attempt to trade for a living.

So how much does it take to trade for a living…let’s see 2 years living expenses, a few 5k account blowups, then your actual starting trading stake. Yes this is the ideal scenario but how many people can start like that? Very few. Most people come into this business with a minimum account (as in minimum required to open) so $2.5K -5K, use $500 margins, and expect to be making 100-200% on their money a month. Is it any wonder why 90% of the people who attempt this fail??? I recently did a post on my blog fittingly titled “Against the Odds – The Process of becoming a Professional Trader” which can be found here: http://tradersmarts.blogspot.com/2009/06/against-odds-process-of-becoming.html Thanks Dr. Brett as always for your insights!

Futures Trader said...

I know this may seem to contradict my first comment but bear with me. The first comment dealt with probabilities, this comment deals with possibilities. In my first comment I specifically didn’t address the amount needed to start trading for the reason that I think for each individual the amount varies. If you are brand new in the business honestly my advice would be to find something else to do unless you have a lot of money (millions) or are a masochist. Seriously. The learning curve is steep and most people do not survive. That being said I do think it is possible to start with limited capital (5K or under) and trade your way up to success. That is the allure that keeps people coming into this business and for a select few it becomes a reality. Look at Richard Dennis for example. Yes these people are the exception to the rule but it is possible. It is a mathematical fact that you can take 1K and turn it into 1 million plus by doubling it ten times in a row trading options. The probability that you will get ten doubles in a row may be very small but mathematically it is possible. The math doesn’t lie.

I think once you know what you are doing the big key is to have enough capital to accomplish two things. The first is having enough capital to withstand the inevitable slumps that occur in this business and the second is to have enough capital to trade without fear of losing which will cause you to do all sorts of stupid things. The expression “scared money never wins” is very true. I think traders limit themselves though when they start thinking in terms of percentage on capital.

For example Dr. Brett mentioned 20K as a sum. Say you want to average $500 per day. That would be 50% a month on a 20K account. If you have never traded before and are just starting out that would be a daunting task. However if you are already a consistently successful trader, for example averaging $500 a day on a 100K account, I think one could average the same $500 a day on a 20K account. Assuming the same contract size and methodology the risk per trade is going to be the same dollar amount. Risk per trade is just going to be a bigger percentage of total capital. It pays to know what you are doing! And by the way $500 a day on a 100K account (which is very realistic IF you know what you are doing) is a return of over 100% a year. The only people who get away with 15-20% a year gains and get paid to do this for a living is underperforming portfolio managers :)

Mike said...

As always Dr Brett an interesting observation, but there is an alternative view.

Suppose one has an account of (say) $20K for starters and the objective is to make with that a $100 per day. Obviously this is an average, but it is a reasonable objective trading futures - NQ - you need to make about 5 points per day. (ES and TF are somewhat more volatile and not recommended for a novice.)

Astonishingly after 1 year (assume 200 days) you will have acquired $20K. A pretty good return.

Of course, the counter argument is that 5 NQ points per day might be ambitious. Ok then assume only $50 per day (2.5 NQ points) and one still has a return of 50%.

This is quite feasible - I know I did although it took me about 6 months to truly/really/absolutely get it into my thick head that loses have to be cut short.

markus said...

Mike, you write:

"Ok then assume only $50 per day (2.5 NQ points) and one still has a return of 50%.

This is quite feasible - I know I did although it took me about 6 months to truly/really/absolutely get it into my thick head that loses have to be cut short."

Just one question, Mike: Do you have made 50% percent or more on your account over several years? And if yes, what were your highest draw backs during those years?

I know it is possible, but to make consistently more than 50% per year with prudent risk taking is not found very often.

Brian, if I wrote "start-up" I mean a new business in general, e.g. bookshop, garage, hairdresser or hightech start-up. The new flower shop around the corner has greater chances to fail not cause of its lack of great ideas but of its lack of financial planning. As far as I heard it from small and bigger business people.

Cheers,
Markus

Brett Steenbarger, Ph.D. said...

Thanks for the observations and excellent points. I'll be posting further on this topic shortly--

Brett