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.

Posted 10 May 2010 in trading.