MONEY MANAGEMENT
Sizing A Futures Trading Account
by Jay Kaeppel
While most traders start out working on a trading system, they
forget that the amount of starting capital is equally important. Here are
some guidelines to consider.
Novice traders focus their attention on developing
a system for entering and exiting the markets. In fact, an entire industry
has been spawned to facilitate trading system development. The age-old
quest for the Holy Grail fuels the simplistic attitude among new traders
that if their timing is good enough, everything will work out. Only after
a trader has become seasoned and taken some hits does his or her attention
become more focused on money management. While money management is a broad
subject, one crucial topic -- sizing an account -- is key.
FIGURE 1: EXAMPLE PORTFOLIO. The example system involves
trading a portfolio of one contract each of five different futures markets
using the same mechanical trading system. This system uses a moving average
crossover approach for entry and exit, and no stops are used. The markets
to be traded can be seen here.
Before a trader can start trading a portfolio of different contracts, he
or she should determine how much capital is needed. Unfortunately, topics
such as sizing an account tend to be an afterthought for most new traders
-- until, that is, they suffer a drawdown of frightening or ruinous proportions.
THREEFOLD DANGER
The dangers in failing to size an account properly are threefold: The
first and greatest danger is that you might tap out (that is, lose all
your money). Consider the naive trader who opens an account with $20,000
and begins trading a group of markets using the trading system he spent
hundreds of hours developing. While the trader has total confidence in
the buy and sell signals generated by the system, he fails to do enough
homework regarding expected equity swings. He doesn't know that the portfolio/system
combination routinely experiences equity swings of $15,000. Of course,
he could get lucky, start making money right off the bat, and then be able
to sit through a subsequent $15,000 drawdown. It's more likely, however,
he will suffer a $15,000 drawdown at some point and stop trading altogether
because he was not prepared financially for the huge percentage swings
in equity.
The second risk is you suffer a drawdown that is such a large percentage
of your trading account you may feel compelled to stop trading, which eliminates
all possibility of recouping your loss. The third risk, at the other end
of the spectrum, involves opportunity cost. If you put $1 million into
a trading account to be overcapitalized but then trade a portfolio that
only generates a 5% annual return, you have cost yourself the opportunity
to profit in other ways.
The key to avoiding these risks is to properly capitalize your trading
account. To do so, you must have some idea of what to expect from your
portfolio in terms of profits and drawdowns, and you must also make the
critical determination as to the type of return you seek and whether you
can stomach the risks involved.
