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Capitalization Issues: How much is enough?

March 22, 2004

 

What would you rather have:

A. 25% Drawdown

B. 50% Drawdown

Ask any investor this simple question and the answer is nearly always A - who wouldn't want less risk! What would you say, then, if I presented a sure fire way to cut your drawdown in half. Here's the secret:

To cut your drawdowns in half, DOUBLE your initial capital. It's that simple.

Why then, are the majority of trading system investments grossly undercapitalized. Why do investors attempt to turn $5,000 into $1 Million? - because that's the American way. Somewhere deep inside, everyone dreams of turning their small savings into a fortune. What this dream fails to consider is the downside.

An investor phoned Attain Capital last week wondering why his account at another broker was in the midst of a 70% Drawdown - after all, he was trading a diversified portfolio of 3 S&P systems with $50,000. The blunt, straightforward answer was because you don't have enough money. Trading three S&P systems with just $50,000 is similar to heading out to a nice restaurant with just a few dollars in your pocket. In short, you can't afford it.

The secret of a majority of CTA and Hedge Fund Managers is that they trade a very, very small portion of their funds - keeping the rest in cash, making an equal dollar loss appear much smaller in percentage terms.

Many individual investors do the exact opposite, asking the seemingly intelligent question; "What is the minimum investment amount?" This question is as common as investing itself, (I'll bet you've said it yourself), but can lead investors down a dangerous path. The better question may be, "What is the proper investment amount".

The old cliché, "If you have to ask, you probably can't afford it" applies here. Investing based on minimums is a dangerous because the built in leverage of futures contracts allows investors to get in way over their head.

The day-trading margin on a full size S&P contract is about $10,000 for example; implying investors could trade any of the popular S&P systems with just $10 K. The first losing trade the system has can show just how dangerous this capitalization logic is, as a routine $2,000 loser equals a loss of 20% of the account. Twenty Percent of the account in just one trade ! ! That is insane. Just five trades like that and you have lost all for your money.

For that exact reason, professional advisors routinely risk no more than 2% of equity on any one trade. To calculate the size of a properly capitalized account, which risks no more than 2% of equity on any one trade, divide the initial system risk by 2%. A system such as Compass risks approximately $1,250 per trade, thus would require a starting capital amount of $62,500. ($1,250 / .02 = $62,500).

Fixed Fractional Formula: Initial Risk / FF% = Initial Capital

Of course, immediately following the first trade, you could be risking a much higher percentage of capital on the next trade, as the dollar risk of the trade has remained constant but the initial equity has diminished.

But why invest $62,500 into a trading system when it can technically be traded with the day trading margin amount of $10,000? Or the developers recommended balance of $30,000….Because many investors unfortunately can't be trusted. They can't be trusted to keep trading the system through a normal drawdown.

While the exact same in dollar terms, a $15,000 Drawdown would represent a 50.00% Max DD on the developer's recommended $30,000 minimum, yet just a 24.00% Max DD on the fixed fractional equated balance of $62,500. Yes, it's the same dollar amount; but investors tend to think in percentage terms, and most investors quit trading a system if it has caused a 50% drawdown in their account - even if they know full well a properly capitalized investor had just a 20% drawdown.

The problem is a mental one between the investor and her emotions. The answer is having a bigger cushion to begin with. Having more room to survive the eventual ups and downs is essential to an investor's emotional well being and long term success.

So do a simple check of your capitalization level by dividing your account balance by the amount of risk your trading system takes per trade. I have listed the risk per trade levels of some popular systems below. If utilizing e-minis, divide the risk by 5 before proceeding. (excluding I-Master)

Compass = $1,250

Daybreaker = $1,300

R-mesa 5 = $1,250

I-Master e-mini = Average risk = $2,000

If that number is equal to or less than 2%, you are a conservative investor who shouldn't see drawdowns greater than 35%, if that number is greater than 5%, you are a very aggressive investor who can expect drawdowns as high as 50%, and if it is higher than 10%, please call me immediately - this is too much risk! Even the best performing, most consistent investments go through troubled times, and living through a tough time when losing 10% of your equity on each trade is difficult if not impossible.

So please check your risk parameters and make sure you are comfortable with the approximate drawdown number your risk per trade level implies. Just because a developer or your broker recommends a certain amount doesn't mean it's law. Question what the corresponding drawdown would look like, and then take a long look in the mirror to see if you could handle it. Those who can are rewarded more often than not.