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Let's say that you are about to start trading an S&P 500 futures daytrading system. Let's say that the exchange minimum margin requirement is $25,000 and the system drawdown is $25,000.
Let us further assume that you want to get started using the absolute minimum account size. Since we are talking about a daytrading system, many of you may be able to trade for half of the required margin or $12,500.
The lure of starting with the smallest amount of capital possible is obvious. We feel that we are getting more bang for our buck. If the system makes $100,000 profit by the end of the year we feel great because we made 800% on our initial investment of $12,500.
If we initially funded our account with $50,000 we would have made 200% on our initial investment of $50,000. Although we made the same amount of net profit we may feel better about using the smaller amount because the return on investment is greater.
In reality trading these two examples can look quite a bit different. If we fund an account with $12,500 and immediately go into a $10,000 drawdown we will not be able to trade the system any more until sufficient funds are added.
In many cases funds are not added and the trader is left with a loss in his account and the words in his mouth, "This system doesn't work". If we initially fund our account with, say, $50,000 we can withstand a $10,000 or even a $25,000 drawdown and still have sufficient funds in the account to trade another day.
Properly funding an account is similar to using stops. We use stops because we do not know if our next trade will be a winner or loser. We properly fund an account because we don't know if a trading system will enter a drawdown period 2 days, 2 months, or 2 years from now. In both cases it makes sense to control our risk.
In some respects a trading system is similar to an automobile. It needs sufficient fuel in order to continue to move forward. If you knew exactly how much gas you needed to put in your car to make a typical 200 mile highway trip would you put only that much in? What happens to you if there is 10 miles of backed-up construction traffic and you find yourself inching along and burning more fuel than expected?
Properly funding your account puts you on the road to successful trading.
Good Trading and Good Life,
Tony Spann
SP Strategies
For those who rely on day trading or swing trading to provide an ongoing income stream into their account portfolio, much time is spent learning all the aspects of trading their own systems effectively. Priority is spent of developing techniques surrounding how to improving their win rate which is certainly time well spent, however there is another side of the equation that a minority of investors and traders should devote time to understanding. That is effective money management. How to develop a plan that can deal with the inevitable times when losing streaks occur can make the difference between staying in the game and blowing out your trading account.
Anyone that has traded futures, options, stocks, forex and commodities in a short term time frame can tell you from experience that losses are guaranteed part of trading. There is no way around it. Even if you are trading a system, or a plan, that has a 60% win rate, you can still expect that 4 out of 10 of your trades are simply not going to work. These are probabilities that we must acknowledge. And what if these 4 losing trades occur in a row? What if 8 of these losing trades occur in a row? This can deliver a sizable blow to your portfolio even though the long term probabilities of your trading plan demonstrate a 60% win rate. Even if your entrances to your trades are perfectly executed according to your trading plan, the follow through due to market mechanics may not provide the desired result due to no fault of your own. However, nobody executes their trading plan 100% flawlessly because as humans we are prone to make mistakes, enter trades late, enter too early because of emotions, etc. So factoring these in to the equation, this brings our win rate down even still.
So how can we, as traders, help to stack the odds in our favor even more that our accounts will be protected when losing streaks occur? One of the best techniques in place for mitigating losses affecting your equity is called Equity Curve Trading. Equity curve trading is a system that simply plots your ever-changing account equity against its own moving average, and then trading decisions are based upon the interaction of your equity line with the moving average.
How can this help? Professional system traders have used this concept for a long time, and many auto-trading computers utilize this simple technique to recognize when the trading program has experienced too many losses. With equity curve trading, once a threshold of losses is recognized, all live trading (trading with real money) is ceased and all future trades are taken in a simulation mode. Results of the simulated trades are still recorded in the equity curve as if they were live trades, but no real money is being risked until the equity curve shows that you are back on a winning cycle of follow through.
Let's explore a simple example of how this would work. I won't get into the details of explaining what a moving average is because I assume if you are reading this you already have an understanding of that. To begin with, we start by logging the profit and loss amounts of each of our closed trades in relation to our account's total equity. If our account is worth $20,000 and our next trade is a $200 winner, then we plot a point at $20,200 on a graph and connect the two points with a line. Our next trade may be a $100 loser so we plot a point at $20,100 and draw a line connecting the last two points. This begins to develop jagged line representing our changing account equity.
Next we plot a moving average of the points on our equity curve. It can be a simple moving average, or an exponential moving average or even some other, more complicated version, but for simplicity we'll speak in terms of a “simple” moving average. If we use a 10-period SMA, we wait until we have at least 10 points on our equity curve and then plot a point which is the average of them all. As our equity curve changes while we trade, we continue to update the SMA with each trade we take and this will begin to form another line moving along with our equity.
Observing where our equity line is in relation to its moving average, we can make some trading decisions about how to deal with upcoming trades. For example, if our equity curve has dropped below the moving average, we would consider taking the next trade in a simulated mode. Many trading platforms offer the ability to switch between trading money from your live account, to simply paper trading in a simulated mode. We record the results of that simulated trade as if it were live and then recalculate our equity's moving average. If the equity curve is still below its moving average, we continue to trade in simulation mode until the equity curve crosses back over the SMA and heads north.
There are many, much more complicated techniques that can be employed using this method, such as scaling the size of your positions in relation to your equity curve's SMA. But in its simplest form, this technique has the uncanny ability to stop you from trading live as you enter losing streaks and then recognize when the winning streaks happening. Will you miss a few winning trades using this technique? Certainly, but the pros far, far outweigh the cons here because equity curve trading will keep you out of many, many more losing trades than winning ones. Employ this technique in your trading and you will be pleasantly surprised to look back and review the money you saved by staying out of losing streaks.