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.