Sunday, June 14, 2009

The Capitalization of Traders: Why It Is Crucial to Success

In the wake of the recent post on capitalization of traders and trading success, I've received a number of emails and comments. Some have lauded me for "telling it like it is"; others have registered their disagreement.

The gist of the disagreement goes as follows: It is possible for a trader with a small account (say $30,000) to trade several lots of S&P 500 eminis, make a couple of points per day, and make a reasonable living. So, for example, someone trading four lots might make $400 per day or around $100,000 per year.

There are several problems with this reasoning, which I outline below:

1) It doesn't happen in reality - The turning point for me came several years ago when I had a heart to heart and confidential conversation with the founder of a large retail brokerage firm. He expressed interest in my work, because he wanted to see more small traders succeed. He stated, based on his company's research, that over 80% of all traders blew out their accounts well within a year of opening them up. That percentage, moreover, was much greater for small accounts, he pointed out, because those accounts took on too much risk in an effort to generate financially meaningful returns. When I asked the brokerage executive how many small traders (i.e., those with less than $100,000 of cash in their accounts) sustained a living from trading, he said he had never encountered such a situation. Yes, there will always be outliers who make outsize returns for a year or two, but sustaining such performance is far, far, far from the norm.

2) Trees don't grow to the sky - Making two points per day sounds like a modest task until you realize that this means that the trader would tripling his or her starting capital *after* expenses. Let's take that trader who has $30,000 and trades four-lot positions. Say the trader makes three trades per day at $5.00 per round turn. That is a commission expense of $60 per day or about $15,000 per year. So not only does our small retail trader need to more than triple starting capital to make that $100,000 income; he or she needs to make a 50% return simply to stay even. Such returns are not achieved by world class investors or traders at professional firms. How in the world can they be sustained by individual, independent traders who lack the resources of the pros?

3) Seeking large returns courts risk of ruin - If you're going to make two points per day, you need to take 4+ moves out of the market with regularity to make up for losing and scratched trades. When the market is moving 20 points per day as a range, that is predicating a huge edge that is not present even among the pros. In order to achieve those 4+ point gains, either holding periods or position sizing need to be extended. That creates larger P/L variability and larger drawdowns following strings of losing trades. Someone seeking 100% annual returns will have to trade large enough that, inevitably, there will be a 50% drawdown during a slump. At that point, the trader must double his/her capital just to break even. Not conducive to making a living.

Some readers may consider me pessimistic for highlighting the improbability of making a living from a small capital base. I, however, see the issue more optimistically. The successful traders that I see tend to have a relatively small edge (*not* taking 20% of the day's range as profits on a regular basis) that is magnified by either high frequency trading (with small, institutional commissions), a large capital base, or both. It is entirely conceivable to me that many independent traders already have the skills and edge to achieve a living from their trading; all they need is the proper base from which to leverage those skills.

I don't pretend that trading $5, $50, or $500 million in capital is the same as trading $50,000; there are important logical and psychological differences. Nonetheless, if a trader is able to make consistent, positive risk-adjusted returns on a small capital base with a scalable trading strategy, there is reason to believe that the trader might be able to sustain a living from his or her work.

The path to success, however, is not through excessive risk-taking in search of monster rewards. Rather, the path involves building skills, achieving consistency in the execution of those skills, and then leveraging those skills through adequate capitalization--either your own saved capital, capital that you raise independently, or capital provided by a bank, fund, or proprietary trading firm.



Curtis said...

But, here is another and more relevant question: can a small trader grow an account over a couple years to a reasonable level? Providing that they do not dip into it for living cost.

That to me is much more of a meaningful and relevant goal, to build wealth and to be one of the best.

Also, for some people generating anywhere from 15k to 30k per year would be enough to live on and competitive with many other job professions. So, I think it would be more relevant to compare it to the lowest common denominator of what is needed.

But, there is another question on my mind. If fixed income such as junk bonds (or p2p lending) can return 10% then you know why spend all the work to get just 10% more?

Dean said...

This is a very interesting discussion, and one - I don't mind admitting - is screwing with many of the assumptions I'd made about what is and isn't possible. While I have enough capital to pass Dr. Brett's minimum standards, I was in no way intending on dumping it all into my trading account any time soon (if ever). I may have to rethink that somewhere down the road.

I guess the bottom line for me is to ask Dr. Brett what a run of the mill ES trader who puts in the work can reasonably expect to be able to achieve in terms of points per day per contract over the long term? If you say 4 pts per day is unrealistic, then what is? Is 2pts too hard, 1 pt?

In the webcast you gave recently I think you mentioned that your own trading size was somewhere between 1 and 6 contracts, which would presumably put you in the same small league. Are you then saying that you couldn't earn a living from trading yourself with such small trading sizes?

Thanks again for spending time on this important topic. It's really difficult to set goals when you don't know whether or not your targets are realistic.

Curtis said...

Here is another way of looking at this issue:

Starting Capital: $50,000
Expected Rate of Return: 20% or $10,000 per year
Inc. Monthly Trading Expenses: -$250
Net Profit: $7,000
Avg. Salary (For My Area): $25,000/year
Trading Profit As % of Average Salary: 28%

So you can see with only 1/2 of your estimated requirement then one could net roughly 1/3rd of an average salary. And on a good year it could account for anywhere from 65% to 75% of typical salary.

The strategy assumed/required would need to be lower frequency with at least a day or more holding period.

IDkit aka Ana said...

I concur with your reasoning, Brett.

Success ultimately rests on good Money and Risk management.

What we think we can make in theory does not happen in reality, speaking as a trader.

Michele said...

I read your original post on this topic with great interest, since I fall into that category of "small individual investors". In addition to trading my small real-$ account, I also paper trade a $100,000 account. I have noticed for more than 4 years that my results in my paper account are always significantly better than in my real account. I could never really fully explain why until I read your post.

On a related note, I see that my real account is up fully 35% since the start of the year (and that was on a fairly conservative strategy involving mostly Dow stocks, with nothing over 300 share positions and no futures). Since that's an 83% annual return, I'm tempted to take the rest of the year off :-) But then there's the post you wrote about not resting on your past accomplishments. Oh what to do!

Futures Trader said...

The bottom line is simple. If you are a consistently successful trader already that averages $500 per day regularly then you should be able to average $500 per day with 30K or 100K or 1 million in capital. It shouldn't matter.

If you are already averaging $500 per day then it means that you already know what you are doing and all you need to worry about is having enough capital to sustain a losing streak and having enough capital to not result in trading scared after a losing streak.

If you are already averaging $500 per day then you are not experiencing 50% drawdowns as is and should continue to average $500 per day with only 30K in working capital to trade with.

Lorden said...

My practice account was $10,000, and I generally aimed for 3 points per trade. While 67% of my trades were profitable there was effectively no profit due to trading expenses eating up the small sums made. Only my losses had any significance - so down 2.1% overall.

I doubled the account size and am now seeing some realisable profits. It is not enough to live on, or even for a good meal in a restaurant.

This is a steady as she goes learning process. I hope to eventually have an account around the order of $150,000 possibly by this time next year if things work as planned.

Paul said...

Dear Doc,

I really enjoy your pshyhological posts but when it comes to trading your thinking is as average Joe no offense. I already posted some of my reasons of why 20%/year is not a target for a trader and i will really not argue anymore but i will advice each and every wanna be trader to remember why did they start atempting to trade in the first place. Is it because they have heard of some money manager making 15-20%/year while having at his disposal millions or is it because they have heard of a few people turning small amount in to a multimillion fortune? If i could only make 20%/year i would take a job cause i would need more than 1 million to make more money than a job would get me, and guess what? i dont need a job doc. ;)

Paul said...

by the way,

"Whatever the soul is taught to expect, that it will build"

...i dont remember wher i`ve heard this but some people should really contemplate about it ;)

ClearAir said...

I am coming to the end of my second year trading and my account has moved from monthly losses to monthly profits and shows clear statistical and financial improvement every quarter.

The idea of trading for a living has been looming large and Dr Brett's post was the last thing I wanted to read.(In terms of the amount of capitol required.)

What has surprised me in the posted replies so far no - one has come forward and said "You are wrong Dr Brett I make a good living on a $50000 account."

Which would seem to confirm the argument.So if you are out there please come forward!

Michelle B said...

Thanks for the follow up post.

I can't disagree with your points.

However, as I had delineated, I was referring to the trading of stock etfs (not futures) using a 4x leveraged daytrading account (based on at least $30,000, to keep above the required level of $25,000). Again, it is absurd to focus on the percentage of the return on the unleveraged cash basis. You are saying that because if the cash amount netted is a huge percentage return based on the unleveraged trading capital, it is not possible. Well, it is.

Leveraged in this case, if risk to reward is adhered, is not a risk of ruin. The positions must be closed within the day per the regulations. It is a combination of daytrading equity (4x the cash amount), exploiting a small edge consistently and frequently, tiny commissions, and adhering to risk to reward stop losses.

It is very difficult, and most traders have to give up before they acquire the skills to accomplish this. I repeat, lots of capital is often necessary so you pay the bills until you become the tiny fraction who can do this approach, but substantial capital itself is not necessary to make a living. I keep my account lean and mean, especially since the dollar is so weak. Depending on the exchange rate du jour, I get those dollars out and into other currency/investments as quickly as I can.

When my account gets over about $50,000, the extra leverage just sits and does nothing because I do not need it to make a living. I run my business as a business, and the business is not based on the return of my original capital, it is based on what I get when I sell the merchandise that I bought.

ClearAir said...

Well that answers my point nicely Michelle B. Thank you.

ES Trdr said...

All good points on the above comments folks.

The most important imo being consistency in trading/trade management! If one trades e-mini's (YM, NQ, ES, TF) etc.... you can easily make $ 500-5K per day avg if you learn Market Profile and use it in conjunction w/ Market Delta footprint chart(as Brett has shown you many times)and the set-ups associated w/ that. It is critical imo if one is trading the ES (for example) that you do your #'s every morning. Lots of good tools out there to help you do a full #'s confluence analysis. Ninja Trader (platform) has excellent trading stats so you can see how well your %'s are. My goal is to achieve above 75% correct trades. Hope this helps.

MacroCall said...

I think for a smaller account, it is far more realistic to trade a longer time frame with some trend following system in futures or forex.

E said...

Wow, what an emotionally charged topic.

My experience has taught me:

More capital is better to avoid risk of ruin

More capital does not protect one from ruin if we dont accept small losses: Barclays/Vic N, Long term capital

It is possible to focus and consistently understand the market rhythm

Understanding the market rhythm still does not equate with consistent emotional discipline

It takes a long time to achieve mastery in this profession

It can and is being done by a small minority of traders

Kobe could out play me hopping on one foot and shooting left handed

I love this business, and treat the market with the respect it deserves

Full time is easer than part time, but... I still am out of the market a lot waiting for the right opportunities when the odds shift dramatically in my favor.

Passive income from other sources takes some of the pressure off trading results, paradoxically making it easier to trade.

Great topic Dr., thank you.

2008 said...

Sorry, I am a full-time trader (NOT trading the SPOOZ) for myself, and for several years, never kept my account above 60k.

That doesn't mean everyone can, just that I did.

Also, as Paul said, I'd quit if I was making 20% a year. In fact, I almost did, and was making well above that %.

kleenup2 said...

Well I did opened a ThinkorSwim account last year with 15 grand and tripled it in less than 6 months daytrading the Russell emini as an experiment adding contract size after each $6000 in equity gain with a max of 5 contracts traded at any one time. Once the account reached $50,000 I took out 30 grand and kept the account at $20 grand and started all over again. Of course the volatility and ATR was much higher but the risk management and trading plan never changed. I have been trading for over 10 years full time so I had the necessary skills and more importantly the discipline to follow the trading plan. Any trader with a rudimentary understanding of price action can make money...the real hard part for most traders is keeping the money. Trading is not investing...when you get profits take them out...don't try to build a $100,000 trading account for the eminis. The best way to control risk in trading is by having as little money exposed to the market as possible. Never ceases to amaze me how few daytraders actually focus on managing each day of trading. I've never seen someone with a trading plan and proper money management blow up an account. In fact most traders that blow up an account do so because bad habits were rewarded early on by the market. A trader can be profitable with a 40% win rate with the proper risk/reward and trading method. The time to worry about commissions is when you open your account...I've seen guys lose a couple grand trying to save a 100 bucks in commissions. Penny wise and pound foolish. The key to trading is keeping losses small...if I have a losing day it is nothing that I can't makeup by the end of the week. The key to making money is learning how to not lose money. Learning how to read the price action is crucial because any losing trade you have could have been a winning trade if you were on the right side of the market action. If you aren't profitable on 40-50% of your trades(a coin flip) then you probably shouldn't be trading.

kleenup2 said...

BTW my account never has more than $50,000 in it at any time. If I only traded futures it would probably have excess cash above $25K swept out each week but since I also do options on stocks and futures I keep the extra cash on hand. Most fund managers never have more than 50% of their account exposed to the market at any given time. Funny how many traders build up an account using proper sizing and risk management and give it all back plus some with 1 or 2 errant and undisciplined trades. Just like the stock market...most accounts take the stairs up and the elevator down.

Q D said...

Trading is not for everyone. It is very easy to make mistakes that can wipe out your account on leverages, such as your stop got blown through on spikes, etc. A 50% per year return is very hard to sustain as there may be a year that put you back 75%, then you'd need to make 300% to get back to even. Don't just think that you can read charts and learn the systems and be able to make money. If so, everybody doesn't need to work, just trading all day long. I would agree that starting with a higher base means you can afford to choose a less risky strategy with lower return and have more success. Dr Brett correctly sighted that many day trading accounts got wiped out in a short period of time. You owe yourself a compliment if you've survived 3 years as a trader.

TNg said...

Do all the cases and scenarios that you have discussed so far regarding to risks and profit with trading also apply to trading commodity futures where one just longs or shorts a few contracts and hold them for a few weeks? These are trading, but not day-trading and in some cases like an investment. Thanks for your response.

siew said...

Hi, very interesting post. here's my experience I am sharing on the subject.

I started trading futures( singapore ) in 2003 with the equiv of US 20000 and had to top it up to 30000 after 1 year because i lost money and wanted to trade bigger in order to make a living. I made 20000 in 2004 but it was insufficient to make a living but was confident that my trdaing was improving and I could make a living if i traded bigger so in 2005 I top up my capital to 50000 and made 67000 which started to look like a could trade for a living.

I also took a fulltime job in 2006 to earn and increase my capital to trade . I did very littl traing that year

I restarted trading fulltime in 2007 with capital of 70000 and then it happened, things clicked, better understanding of opportunites, bigger positon size and made 150,000 that year so have been trading with 100,000 to 200,000( currently )capital and sizing trades depending on market conditions and opportunities.

2008 because of it volatility was a fabulous year fro making money and this year apart from the 1st couple of months slowe but still generating more than 50% return ( based on capital amount)

My learning it was ok to strat with a smaller capital when starting and you are learning BUT when you learnt the ropes and confident based on actual performance that you can indeed trade for a living you need to somehow increase that capital because it allows you to trade bigger and take adv of the opportunites.

Why does my cpaital alloted to trading vary ( or maybe I should say position size vary? )I try to get aggresive when the edge is in my favour and trade small when it is not or not at all, which is kinda of hard for us trading professionally and fulltime..

Jason Russell said...

It actually is possible to build capital and wealth by intra-day trading. But the key thing is you cannot touch the money for years until it grows into a large sum. You also want to use an IRA or an account where you do not need to pay taxes every year on your gains. I know from extensive backtesting and live real money forward testing of my strategy that you have to get large winners in order to make an average of 1-2 ES points per trade over the long term. And when I say long term, I mean 1+ years. You make a living by trading large size, and managing your money properly, which most (99%) of traders don't get that concept.