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.