The Dangers of Undercapitalized Trading

Commodity futures trading offers the potential of immense rewards with only a small amount of capital. This is what lures many traders into the markets.  However, it is a rarity for someone to turn, say $1,000-2,000, into a large amount of money without suffering drawdowns or price movements that erase their entire capital very quickly. The few lucky souls that have achieved this are few and far between and I doubt that their success happened overnight.

Indeed, it probably had nothing to do with luck. I suspect that they had rock-solid discipline, were well-informed, and selected trades very carefully.  But, more importantly, they most definitely employed very rigid methods of risk management from the very outset of their trading.

 

Small trading accounts don’t fare well

For the rest of us, who are bound to make many costly mistakes when we start out trading, a more sizable amount of capital is needed to withstand the whipsaws that occur in all markets. Prices regular move in waves of peaks and troughs – a whipsaw action. If you don’t have the capital to sustain these regular movements then you’ll get knocked out of the market and have to accept the losses.

This typically happens with under-capitalized traders who are so heavily margined that even the smallest price movements will trigger a margin call (which should never be met!) or force their broker to offset the position. Of course the trader takes the losses and then, to his exasperation, often witnesses the price turn back in the direction that he originally bet on. Drawdowns, or the amount of trading losses that occur with any trading system over a period time, is another element that must be factored into the total picture of available capital.

Losses are a part of the game, pure and simple. They happen to everyone and must be accepted in order to achieve success. The point, of course, is to limit and curtail losses as much as possible, but with too little capital you’re liable to get knocked out the market altogether when you find that you don’t even have enough capital to meet minimum margin requirements.

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My personal experience trading without enough capital

This can be frustrating for traders who are hell-bent on making some money with what little capital they have. I remember experiencing this during my first year of trading. I had saved up a few thousand dollars of capital and carefully chose my first trade. As it was, things went well and I realized about a 100% return in a few days.

Of course this was the worst thing that could have happened to me. I felt like I was invincible and couldn't make a mistake. Thereafter, I proceeded to repeat my success and after a week had lost all of my trading capital.

Well, now I’m coming to the real point of my story, I became determined to get the money back. I did this over the next six months, each time trying to trade with just enough capital to meet minimum margin requirements. I was hoping for that one “big win” that would make me whole again. Naturally, I ended up losing even more money, just a little bit at a time. However, my losses were small compared to some who fall into this trap.

My desire to make it big by continually committing 100% of my meager capital ended in disaster, as it usually does for everyone who makes this mistake. Eventually, I stopped myself and summoned up the patience and discipline needed to save an adequate amount of capital for trading. I became determined to do it the right way and not fall prey to this type of desperation ever again.

money-management-course

How much capital is needed for futures trading?

It’s difficult to give a minimum amount of capital that traders should start with. This is because every trader’s goals and risk tolerance levels are different. It really depends on which markets and what type of trading one will be doing. For example, day trading, the e-minis, and spread trading all require less margin than outright futures.

Whatever the amount, this capital should not be relied upon for living expenses. It should be expendable money only! I should have said that in the opening lines, but better late than never. Also, the markets you trade will determine margin requirements as well. If you want to trade crude oil you won’t be able to do so with a couple thousand dollars.

Many traders define the amount of money they will risk losing from a trade, but don’t set the same limits on the amount of margin money they will commit to trading. I set limits on the amount of margin money I will use for trading. For instance, If I only allow myself to commit 30% of my capital for margin requirements, then a $10,000 account balance means I can only use $3,000 of it for margin. This defeats the power of leverage somewhat, but gives me an added measure of security. So, there are many variables and rules that come into play when allocating your trading capital. 

Remember that the types of markets you trade, margin commitments, and your money management rules should all be laid out beforehand in your futures trading plan.

As a rule of thumb I would say that trading with anything less than $5,000 is too risky. With anything less your chances of surviving losses and being able to trade another day are severely limited. The preferred minimum would be $10-20,000. With this amount you have more breathing room and trading opportunities available to you. Remember though, it is just as easy to lose $10,000 as it is to lose $1,000 – there is never room for sloppiness in your trading habits.