A scientific method to calculate how much capital do you need to start trading

I typed a rather long reply on the SMB Training blog to the question of how much capital one needs to start trading. So I thought I might as well expand on this frequently asked question for traders visiting here. Here is my process.

The first thing to realize is the fact that trading is a business. And like any business, the single most important question to ask is — what is your bottom line? That can be simplified to two parts. What do you expect to make and what are your costs? Let’s consider your expectation first.

You can’t estimate your expectation if you don’t know what you did (that would be a haphazard guess). When I dipped my hands in trading forex the first time. I started by paper trading a demo account for a few months. As I was unfamiliar with trading forex, that provided me with a risk-free opportunity to learn. Equally more importantly, it serves as a Monte Carlo experiment (perhaps more on this another time) to figure out my expected performance statistics in this particular market (for example, here’s my January 2010 review).

That is how you can scientifically derive your trading expectation. Based on history. Yes, past performance is no guarantee of future return. But at least it should give you a ballpark figure. So unless someone can suggest a better method, you need to seriously grind it out on a demo account first. (I only said this is straightforward. I didn’t say this is easy.)

Fortunately, that is the hard part. Next step to figuring out your costs is easy. Just calculate your trading commission, data fees, etc. Then estimate how much fees you are paying per trade. This is the cost basis of your trading.

Then here are the steps for calculating your initial capital need.

1. Calculate your average return percentage (of total principle) per trade from your paper trading.
2. Make an educated guess on your capital need, just to initialize the numerical process.
3. Calculate how much average amount of money you expect to make per trade using #1 and #2.
4. Divide your cost basis per trade with #3 to get a percentage of cost per trade.
5. Reiterate steps #2 to #4 until your percentage of cost per trade is acceptable. i.e. increase your capital (#2) if your percentage of cost is too high, and vice versa.

For example, say you expect to make an average +1% of your total account per trade (step #1). Then let’s say you thought an $10,000 account is enough (#2). $10,000 x 0.01 = $100. So you can expect to make an average of $100 per trade (#3). And let’s say your fees is $5 per trade. A round-trip (buy and sell) would cost you $5 x 2 = $10. Thus, #4 is found by $10 / $100 = 10%. Which means you’ll be set back by 10% on every single trade. That cost percentage is too high. Then let’s double the capital to $20,000 and go through steps #2 to #4 again.

Assuming your fees per trade is fixed, which is most likely for small accounts. You’ll find that your cost percentage is 5% for a $20,000 account based on the same conditions. Perhaps 5% is acceptable for you? If not, raise your capital estimate again and re-do the calculations (a spreadsheet would be useful).

The process is straightforward and unambiguous. Once you’ve done your paper trading, the actual calculation should take less time to do than reading this post.

I just made a grave fundamental mistake in my CVE.TO trade

Cenovus Energy (CVE.TO) tested 27.50 support and then bounced back to break the short-term downtrend line above 28.50 or so, see Figure 1. Naturally, I don’t want to turn a profitable trade into a losing one. So I wanted to sell my puts options on CVE.TO while I can still exit at near breakeven. However, as I am new to Questrade and unfamiliar with their interface, I made the careless mistake of buying six more contracts instead of selling the six that I have!

Cenovus Energy (CVE.TO)

I realized my mistake soon afterward from checking my account. Imagine my surprise to find that I am an owner of 12 puts contracts on CVE.TO. So I wanted to cut my losses immediately. Unfortunately, the energy sector (XLF) and crude oil just broke above some key resistances and CVE.TO bumped up a few more points.

The right thing to do is to ignore my unfortunate losses and just exit the position, as that was what I intended to do. But I didn’t.

I decided to not panic and analyze the stock yet another time. CVE.TO is definitely weak. It is lagging behind others in the sector. Other energy companies are breaking above resistance levels but CVE.TO is still below its 29.50 resistance. Yet, the fact is that the trend in the sector is upward. Which is very bad for me.

I am still holding this short CVE.TO position over the weekend as it hasn’t broken my 29.50 mental stop yet. I can give my bearish reasons here upon observing the tape this afternoon (e.g. Goldman Sachs Canada is dumping shares), but they would just be excuses under the current circumstances. In any case, this is an embarrassing confession as I’ve violated one of the most basic rules of trading.

This position is near breakeven on paper as of the close. But who knows what can happen over the weekend. Rather than risking 3%, which is already too much, I am now risking a maximum of 10% on this trade. What have I done…

The high commission in trading options is affecting my decision. If this were a forex position, I would have dumped it all without giving it a second thought. This is a sign for me to stop trading options altogether. It is better to stay with a long-only equity strategy in my RRSP than get eaten up by commissions or take excessive risks as I am doing now.

How to backup your data on the cloud with ease and for free

Dr. Steenbarger’s recent harddrive failure reminded me about the importance of backing up my data. Everything that I do with trading is on the computer. Consequently, I have many files that are vital to my trading. From web bookmarks to chart templates to source codes, I would have to make a checklist to ensure that I backed up everything frequently. But only if I were to do my backup manually. Being the lazy and cheap person that I am, I don’t like the idea of forcing myself to backup frequently. That is why my folders are synchrnized automatically to an online file server using Mozy Remote Backup. I don’t have to do a thing to know that all my important stuff are safe.

There are two reasons why I choose Mozy. It is one of the two biggest names in the business (the other is Carbonite). It is the only one of the two to offer a free for lifetime 2GB online backup space (affiliate).

The benefit of using Mozy is that it actively synchronize my files to their cloud storage server. These are files that I change often. It makes sense to use Mozy to monitor and back them up automatically so that I don’t have to worry about them.

Still, I have another 50GB+ of personal photos, videos, and documents that won’t fit in this free 2GB space. Which is why I only use Mozy for my frequently changing or critical files (mostly trading related). For the rest of my 50GB+ data, they are typically static content (e.g. photos and media files). So there is not much point for me to pay a monthly fee. I rather spend a few minutes a month to make backup DVDs or upload them to my Amazon S3 account. That way, I have all my data backed up and get to keep my $5 a month (price of monthly subscription fee for an unlimited storage space backup) too.

I am not being paranoid. Another one of my computers died on me a few years back with no prior warning. Its power supply suddenly blew up in smoke and sparks one day. The scene was quite spectacular. More than a few components were damaged then. I doubt that I will see that kind of fireworks again. But who knows what else could go wrong with this aging computer (4 years and counting)?

A data failure with my computer would indeed be very costly for me. I invested a lot of time and energy on my trading work. If my harddrive were to fail, I may lose all of that work if I don’t have a backup. That is why I have a free automated data backup plan which doesn’t require me to lift a finger.

Is a $5000 Questrade TFSA trading account cost effective? – Part 1

I recently talked about the benefits of a Questrade TFSA trading account. In this series of posts, I will take the other side of the debate. That is, to answer this simple question, with a $5,000 initial deposit, is a TFSA trading account a cost effective means to allocate your asset?

Part 2 and Part 3 of this series discuss my derivation of a spreadsheet to do the job. Part 4 is the conclusion along with a free interactive spreadsheet that I made so that you can get your own results with a few keystrokes.

The first step in any trading or investing is to consider your costs. After all, trading is a business and your bottom line is well… your bottom line (cue eye rolls). Every penny added to your costs means that you’ll just have to perform that much better to overcome it. Easier said than done. As such, here is my cost analysis in response to my previous post about the Questrade TFSA trading account, in particular.

Feel free to use this as a guideline for your own cost analysis if you’re considering opening a Questrade TFSA trading account (affiliate link) yourself. We each have our own unique financial picture so this cost analysis is merely a peek from my personal perspective. Here goes my calculations and rationales.

The minimal commission on stock trades is $5 at Questrade. A $5 commission may not seem much to most people. But consider this. For a $5000 account, $5 is 0.1%. On a basic single-lot round-trip (buy and then sell, all shares at once) trade, the total commission is $5 x 2 = $10. Thus, I will be 0.2% behind in my account on each and every trade!

Yes, 0.2% is a small number. However, take a look at my trading log from my recent forex trades and you’ll see that I made more than 10% in 4 months by taking 0.2% here and 0.3% there. In fact, if we consider the statistics frommy best forex trading month last year, my average net profit percentage per trade is 0.12%. I totalled 4.19% net profit on that particular month by raking in a lot of those +0.12% trades.

As you can see, a 0.2% commission would effectively break my profitable system. So conclusion #1. I cannot trade my TFSA with the same trading strategy as my forex trading. In other words, no aggressive day and swing trading.

In my next post in this cost analysis series, I will see if I can find an cost optimal risk amount to use per trade in a Questrade TFSA trading account. And if I can’t justify it, well, bye bye TFSA trading!

How to stockpile a trade position one step at a time

Arguably the single most important skill a trader needs to master in trading any market is to cut your losses short and let your profits run. This is simply another saying of managing risks and maximizing opportunities. However, this is easier said than done. Ever tried to cut your losses short but only to see the price run in your favour soon afterward? Or, that you’ve built a sizable and profitable position only to see it turn into a loss? As with much of other trading skills, managing your trade is not an exact science. That is why you need to have probabilities in your favour on every step. You enter a trade because it is likely to be profitable. You exit a trade when it is not. If you can apply this axiom on every trade you do, it is likely that you will be profitable, with all things being equal. So what does this have to do with cut your losses short and let your profits run? In this post, I will discuss one trading strategy which I use to do exactly that.

The key to this strategy is divide and conquer. Instead of taking one trade for each position, consider taking multiple smaller trades by scaling in and out of a position. That way, you can have more freedom in your trade by using your position size to your advantage. Here’s the gist of the strategy and the rationale for it.

The rule is simple: increase a position by scaling in as the probability of success increases; and decrease a position by scaling out as the probability of success decreases.

One way to do this is to add on a position as the price breaks support on a faster timeframe. You keep adding on this position as long as your trade setup (on a higher time frame) is valid. At the same time, you limit your risk by lowering the stop of your previous trade to breakeven. That way, even though you are stockpiling a position, the overall risk stays the same. This is an essential step in the technique. Otherwise the risk would just multiply. It is as much managing the entries as well as the stops/exits.

Let’s put this into perspective with a real-world example. Figure 1 shows the support levels for my EUR/CHF short on a 3-hour chart. I identified this trade using my FTC setup on the daily chart. The failed break above 1.4800 on January 14 was the signal for entry. I took an initial short position risking 0.20% of my account as EUR/CHF reverted back below 1.4800 (first support, not marked).

Then I kept adding on to this position below 1.4787, 1.4761, and 1.4742 supports as shown in Fig. 1 with the horizontal dashed red lines. On each subsequent new entry, I move the stop on the previous entry to b/e. I only risk 0.1% on each of these additions with half the position size after the initial entry. As I keep adding, I keep moving the stops one step behind. So on my third scale-in, my initial stop have locked in some profits at a price level between my first and second entries.

Figure 2 is the same chart but with the actual filled orders (yellow triangles) and current stops (red lines) marked. As you can see, I have effectively accumulated a sizable position size in this short while limiting my risk to just a fraction (0.2% versus 1.0%) if I were to enter my maximum size all at once. Furthermore, my confidence and probability of this trade increase gradually as I see the short-term support levels break one after another.

EURCHF, 3-hour, showing supports

EUR/CHF, 3-hour, showing orders

There are limitations to this strategy. First of all, this strategy is mostly suitable for trading setups with an expected high reward/risk ratio. You might not want to use this for a range trading strategy as there’s probably not enough price move to break the trade into steps.

Secondly, this technique is mostly for an automated system or longer term manual strategies (hours or more). Just so you have sufficient time to manage all these extra work without adding on an unnecessary amount of stress.

Lastly, an obvious downside to this approach is that your account will take a hit from the spreads and commissions for each move. So do take those costs into account in building your own adaptation to this concept.

Now that I’ve discussed my scaling-in technique, what do you think?

Update January 22: I’ve closed this position and it turns out to be one of my best trade ever.