Today’s Trading Lesson From TradingMarkets

Meet Chuck.
Chuck reads a couple of trading books, buys a new computer, opens an online
brokerage account, and starts daytrading. “Wealth beyond belief,” Chuck thinks,
“is just a few short months away. I know it, because lots of other people are
doing it.” He vows not to fall into the trap that many newer traders fall into.
He breaks out his trusty calculator, and carefully plots out how much he’s going
to risk on each trade–what his commissions will be, his risk/reward ratio—he
has everything figured out.

A few months later, Chuck’s account blows up. He
picks up another couple of books, attends a seminar or two, and tries it all
over again. Several months later — kaboom! This
time, Chuck buys an expensive trading system; he’s sure that he now has the
“Holy Grail.” “I’m just gonna let the program tell me what to do,” he says.
Thinking the entire time of the boat he’s going to buy, and all the blue-water
fishing he’ll soon be doing. After another few months, Chuck explodes again.

What went wrong?

Chuck didn’t do things too differently than a lot
of would-be traders. He did some reading, went to a few seminars, even bought a
program that he thought would bring him riches. A little knowledge can be a
dangerous thing. What he didn’t do, though, was start his account with
enough money. Chuck was undercapitalized, and because of this, his
trading was doomed from the start. (No
offense to all you Chucks out there; it’s all in fun.)

While there’s plenty of information available on
technical analysis, money management, and various trading strategies, there is
unfortunately not a lot of talk about something that is just as crucial to your
success: capitalization.

Starting your daytrading account with an ample
amount of money is a basic prerequisite for success.
Starting with too little money can take you out of
the game early. Losses are a part of trading–even for seasoned veteran
traders–but they tend to be greater for newer traders. If you don’t start with
enough money, you may find that your account is tapped out before you really get
the hang of it.

How much should you start out
with?

To answer this, let’s look at an example:

Say you’re a daytrader, starting out with
$10,000. This means, assuming no margin, you can buy 100 shares of a $95 stock,
200 shares of a $48 stock, 300 shares of a $32 stock, give or take a few bucks.
Using good money management techniques, you don’t risk more than 2% on each
trade. (That’s only $200, by the way.) On a 100 share position, that’s 2 points;
on a 200 share position, 1 point, and on a 300 share position, about 3/8 point.

Let’s assume you’re daytrading 300 share pieces,
you are setting stops at 3/8 point, and you have three losses in a row. That’s 1
1/8 points loss, plus commission, let’s say, of $15 per trade, or $90. All of a
sudden, your $10,000 is down to $9527.50, almost a 5% drawdown in one day.
It doesn’t take a math wiz to figure out pretty
quickly that you can’t do this for too long without running out of money. At
this rate, assuming nothing changes, you’ll run out of money in about 20 trading
days. Your $10,000 is not going to get you too far. You’re going to need to book
some profits at some point, to turn things around. Figure you will have some
profits, but that during your learning curve as a newbie, you’ll pay your share
of “tuition.” Everyone does.

The solution is to treat your trading as a
business (see

Daniel Beighley’s trading lesson). Any business–including trading–
requires start-up capital. Unless you’re trading from an office, computers, data
feeds, and software are all part of the start-up costs. (Even then, you’ve got
monthly overhead to deal with). But the start-up costs for a trader don’t end
there. Your drawdowns are a cost of doing
business. You will lose some money for a period
of time. Count on it. Plan for it. As Dave Landry told me, when you’re new to
trading, “You’ll never be as dumb as you are now.”

If you begin full-time daytrading with, say,
$50,000, and simply realize that there’s a very good chance that at some point
your account will be worth only $30,000, or even less, you’ll actually be ahead
of the game–at least mentally. You’re prepared for it. You know that it’s a
cost of doing business, that it’s to be expected, and that you can recover from
it — provided your learning curve ramps up.

Pending NASD rules will require daytraders to
maintain a $25,000 account minimum. Many firms now require this amount to open
an account and trade with them. The NASD knows that there are a lot of folks out
there who have been led to believe they can become wealthy starting with only a
few thousand dollars, and are tightening the rules.

But simply having the money is only one part of
the equation. Where you get it is the other. How do you get your trading
capital? Maybe you’ve been planning for a while, and you’ve amassed a wad of
money. Good planning. Or maybe you borrow it. Bad idea, in most cases.
I’ve known guys who maxed-out their credit cards to
get started in the trading business. While this is a quick and easy way of
getting cash, the effects from it can be potentially devastating. Worrying about
trading profits is hard enough without having to worry about debt service on a
credit card as well. In this case, you’re not concerned with good trading,
you’re concerned about making payments!
Don
Miller talks about this in TradingMarkets World “Meet the Traders” when he
tells newer traders to worry about “trading well,” not making money.

Quitting your day gig to daytrade is a bad
idea—unless you’ve got a pile of money to keep you afloat with no worries, for
a year or two. It’s like the old joke:

A: “Start
with two million!”

A fantastic way to learn is to begin trading on a
part-time basis, thus ensuring an income stream while honing your skills. The
advantage here is that you’re not trading with the “rent money.” Talk about
stress—this is one you don’t need.

Another excellent idea is to learn to trade the
intermediate term first.

Loren Fleckenstein and

Gary Kaltbaum offer excellent daily insights. Because of the nature of
intermediate-term trading, you can still work a full-time job. If you find
you’re successful, try moving to swing trading. While a little more difficult,
it’s still possible, with some juggling, to hold down a job and swing trade. If
you have the knack for swing trading, you have a good chance of succeeding at
full-time daytrading .

Simply being a member of this site shows your
commitment to and desire to improve your trading. The fact that you’re reading
this piece means you’re serious. The good news is: If you are able to digest and
apply even a third of the valuable
information on this site, you’ll be way ahead of the next person. Your tuition
period, if you pay close attention, will be shortened.

Summary

1. Start with enough money
2. Assume 1/3 to 1/2 will be gone at some point
3. Continue good trading methods
4. Don’t trade with the rent money
5. Don’t quit your day job until you’ve
   established consistent weekly profitability

Many people think of trading as their goal. In
fact, trading is a journey–a journey that can take you to both financial and
emotional extremes. Every trader will tell you he/she learns something from the
market every day.

Even the best black box systems experience
drawdowns. Your ideas and strategies may be just as good, if not better, but you
must give your concepts a fair chance by starting out with enough money to make
it work.