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Author: Ben Millane Article source: http://www.kabish.com/. Used with author's permission.
What account size do I need?
How much money can I make with trading?
First of all, let's clarify a common misunderstanding: You never risk your full account size. You always have a "catastrophic stop", and it is important to define the "ruin" before you start trading. Let's say you start with a $10,000 account, and you decide to stop trading if you lost $2,000. In this example you are "ruined" if your account decreases to $8,000. Though you invest $10,000, you only risk $2,000.
Back to the first question: "What account size do I need?"
The first factor is the margin required by the exchanges. The margin is the "security deposit" that you need to have in your account if you want to trade. This margin varies depending on the contract you want to trade, e.g. $3,938 for the e-mini S&P and $1,688 for the 30 year Treasury Bonds. Many brokers offer a 50% deposit? on this margin requirement if you daytrade, i.e. you open and close the position on the same day.
If your trading system requires trading 1 contract of the e-mini S&P, and you hold the position overnight, then you need at least $4,000 in your trading account.
The next factor is the expected drawdown. If you would only deposit $4,000 in your trading account, the first trade moves against you by more than $62, and the value of your account falls below the margin requirement of $3,938, then you receive a "margin call". Many electronic platforms automatically liquidate your open positions, and don't let you trade any longer. Therefore, you need to know the maximum drawdown of your trading system in the past. Let's say your trading system had a maximum drawdown of $2,200 in the past, then you need at least $6,200 in your trading account: $4,000 margin requirement plus $2,200 "buffer" for a possible drawdown. A safe approach is to double the maximum drawdown, because usually the worst drawdown is still to come.
Let's say that based on these calculations you decide to fund your account with $8,000, and you define your "ruin" as $6,000, i.e. you are willing to risk $2,000 for your trading adventure.
How likely is it that you lose the $2,000 you are willing to risk?
Assuming you have a well tested and robust trading system that is likely to achieve similar results in the future as in the past, then you can use the log-normal distribution to calculate the risk of ruin. In the following example we will use the values of our e-mini S&P Trading System "Coin Collector".
The profit factor of this system is 1.42, i.e. for every dollar you lose you earn $1.42. The winning percentage is 70.5%, and the average winner is $129. Using these figures and the results of the past trades, you can calculate the "risk of ruin" for our system:
The probability of losing the whole $2,000 that you are willing to risk in the next 30 trades only is 1.4%. That's very low. If you decide to risk $3,000, then the probability of losing all the money in the next 30 trades decreases to 0.07%.
Let's talk about the next question: "How much money can I make"?
You first need to calculate the average profit per trade by dividing the overall profit by the amount of trades you made. In our example the "Coin Collector" produces an average profit of $37. Next you need to multiply this number by the trading frequency. The "Coin Collector" produces in average three trading signals per day, i.e. you can expect $111 per day per contract.
An average week produces 15 trades and $555 profits. Deducting commissions and slippage you can expect $842 in two weeks (=30 trades).
If you catch a lucky streak you could even make more. So how likely is it to MAKE $2,000 within the next 30 trades? The probability of making $2,000 is 20.4%.
Trading is about risk and reward: you want to get a decent reward for your risk. In our example the probability of losing $2,000 is 1.4%, and the probability of making $2,000 is 20.4%. That's an excellent ratio!
Conclusion:
Your account size is determined by the margin requirement set by the exchanges and the "buffer" you should have for an expected drawdown.
The question "How much money can I make?" can be answered using the performance report of the past results of a trading system. Keep in mind that these figures are only valid if you developed a robust (and not a curve-fitted) trading system.
Using some statistical functions, you can then determine the "risk of ruin" and the probability of making a certain amount of money. That's what trading is all about: risk and reward.
---------------------------------------------------------------------- The author, Ben Millane, is a recognized author on the subject of trading systems. His website, http://www.rockwelltrading.com, provides a wealth of informative articles and free information on how to achieve your financial goals through trading.
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