Tips for Trading with a Small Account
08/08/2014 6:00 am EST
Richard Cox of TradersLaboratory highlights the tools for proper preparation and the setting of realistic goals, which are vital when trading with a small account.
Smaller retail traders have been able to enter the market with the ability to execute high leverage levels with very few limitations by using options, forex, binary, and other methods of investing. But the unfortunate reality is that some small traders are caught up in the hype and believe that quick riches are easily attainable even when starting with the smallest account sizes. The trading environment has been somewhat democratized but it has also made many traders with small account sizes vulnerable to quick market reversals that can wipe out an entire savings balance.
For these reasons, it makes sense to assess the rules and tools smaller traders must utilize in order to stay in the game and keep their accounts growing. There are many market experts that will actually suggest there are no real differences when trading, and that a smaller account should be approached no differently than large institutional trading accounts. But while this is largely accurate, there are still some things that smaller traders must keep in mind in order to avoid a margin call situation that could deplete your entire trading account.
Starting with Realistic Expectations
The first problem that plagues most new traders is the problem of unrealistic expectations. This problem can take many different forms. But in most cases, you will see a new trader with a small account get a few successful trades in a row and then start to expect that those results will be duplicated forever. These traders will then start to do the math and figure out how much money can be made each day, week, month, or year. This is destructive, however, because it is taking your mind off of what you should actually be doing (analyzing the market and isolating high-probability opportunities) and centering it instead on scenarios that could make you rich with little effort.
Markets are never this consistent, and there will be always be situations where you do better or worse than you have originally expected. Trading projections are generally not very useful (especially in the early stages) because there are going to be many events for which you are unprepared and many market scenarios that might not necessarily conform to your original trading plan. The unfortunate reality is that you are not going to be able to turn a $500 account into $1 million in a month or a year. Even if you max-out on your available leverage, these are unrealistic expectations that should be disregarded immediately if you plan on being an active trader for the long run.
Large/Small Account Sizes: Similarities and Differences
At the same time, markets are markets and trading is trading. The argument can be made that a $500 account should be traded no differently than a $1 million account (other than the fact that trade sizes should be proportionately smaller). There is a good deal of truth to this, because the probability for a given chart pattern will not change depending on the amount of money that is in your account.
In these ways, large and small account sizes are essentially no different as long as you keep your risk percentages to appropriate levels. (Conventional wisdom here suggests that you should never risk more than 2% to 10% in any one position.) It is also important to remember the characteristics of the markets you are trading. One example would be differences in the ways gold (GLD) prices vary relative to currencies. When viewing the market in this matter, the real issue is the strength of your strategy rather than the size or your position. The key here is to view your account in terms of percentages, rather than in dollar figures.
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In other words, look to make back your 2% on the trade, rather than trying to make $100 or $1,000 on your trade. It is amazing how often this mistake is made, as traders start to look at the market as a source of income rather than as a living organism that does not care about whether you win or lose (or if you have made enough money to cover your monthly bills). It is also another reason why options trading strategies might even make more sense for new traders. If you expect to stay in the game you will need to view your balance in terms of percentages rather than as a potential dollar figure.
Stop Losses and Market Anomalies
Large accounts are better positioned and better able to weather market anomalies. As a personal example, I remember being short the Euro/Swiss France currency pair (EUR/CHF) when the Swiss National Bank (SNB) decided to construct a price floor at 1.20. This was done to prevent excessive strength in the CHF but the move was largely unexpected and took many traders (myself included) by complete surprise. I was in front of my trading station when this occurred and I saw prices climb by more than a thousand pips in minutes. I did not have a stop loss in place when this move occurred and this created the biggest loss of my trading career. Fortunately, my position sizing in this case was relatively small and I was able to avoid the total depletion of my account.
But what would have happened here if I was just getting started? Would I have been able to withstand the losses taken by such an unexpected move? Prior to that day, I never would have guessed that markets (especially the EUR/CHF, traditionally a low-volatility forex pair) could move 1,000 pips in a day—in any direction.
Of course, I was wrong in this case and the mistake turned out to be very costly. For these reasons, stop loss placement is much more important for those with small account sizes as there is much less flexibility and margin for error. The market can (and eventually will) surprise you and destroy your expectations. For those with small trading accounts, proper preparation here (a stop loss) is vital and could potentially be the only thing that keeps your account active when a market anomaly occurs.
Conclusion: Does Size Matter?
So, here we come to the ultimate question: Does account size matter? Unfortunately, the answer is a vague 'yes and no.' "Having a small account size means that you will absolutely need to take certain precautionary measures (i.e. having a relatively conservative stop loss that is in place)," said Sam Kikla, markets analyst at BestCredit. "This is the only way to protect your account from market anomalies that can erase all of your previous gains in short order." Another factor to remember is that leverage is much more dangerous when your account size is small. There is absolutely no reason a trader with a $500 account should ever be taking 200:1 leverage. At this rate, it would only take a small string of losses to completely eliminate your ability to continue trading.
On the plus side, smaller traders that obey these rules (and focus on percentages rather than Dollar figures) will have access to the same returns as those with institutional accounts (again, in percentage terms). The real issue here is whether or not you are taking an overly aggressive approach to your trades. This is not a viable option for those with smaller account sizes. So, there are important differences that can put smaller traders in more difficult positions. The positive here is that most of these difficulties are removed when you keep a conservative trading approach, use active stop losses, and structure your trades so that they are working as a percentage of the whole.
By Richard Cox of TradersLaboratory