Reasons Traders Fail – #1 Undercapitalization

The world of trading can be as daunting as it is exciting. After experiencing a few nasty losses, the prospect of success being a little tougher to achieve than they first anticipated dawns on a new trader and they will start to look for answers.

One scary statistic that usually crops up is that 90-95% of traders fail. Of course, nobody ever thinks that they’ll be part of the 90-95% group that fails. But even if you’re not, of the small percentage that aren’t failing, how many make a decent living from trading? How many make good living or even become wildly successful? How many who are currently successful, end up blowing up their trading accounts and changing careers?

Trading is fraught with risk and traders must be vigilant if they are to avoid the fate of so many others. The first step on this journey is to be aware of the potential pitfalls ahead.

In the first installment of this series, I’d like to consider undercapitalization as one of the reasons traders fail.

What is Undercapitalization?

Undercapitalization means you don’t have enough capital to ride out runs of poor performance in order to see your trading strategy’s edge play out. A strategy with a win rate of 66% over a set of 100 trades, could have a loser every third trade. It could also have a run of 34 straight losing trades followed by 66 straight winning trades. A win rate tells you nothing about the distribution of wins.

The historical probability of a strategy is a guarantee of neither the future distribution of winners & losers nor the future win rate.

“The historical probability of a strategy is a guarantee of neither the future distribution of winners & losers nor the future win rate”

Take a look at the following chart:

Risk of Ruin

This shows the basic relationship between the amount of risk a trader is willing to take on each trade and the number losing trades they are able to withstand, up to the point where their starting capital has been depleted. It doesn’t take into account fees & commissions and it ignores margins.

A more realistic model would include these. It would also include a rather more likely situation where a trader experiences a slump in win rate or win:loss ratio rather than simply the losing streak that it assumes. The curve is the same, but if you also factor in the number of trades you take per day, it gives you a good idea of how long you’d last in this sort of scenario.

What the chart does show is that the relationship between number of trades and % of starting capital risked per trade is exponential. The number of trades dramatically reduces when risk per trade is increased from 1% to 2% and beyond. This is why you’ll often hear about using 2% risk as a good rule of thumb.

The relationship can be calculated as follows:

(Risk per Trade ($) ÷ Starting Account Balance ($)) x 100 = Risk per Trade (%) ∴ (Risk per Trade ($) ÷ Risk per Trade (%)) x 100 = Starting Account Balance ($)

The second formula allows you to input your expected risk per trade in dollars, along with the amount of risk you wish to take per trade and calculate your required starting balance.

Pretty simple, but necessary stuff. If you know where you stand, you’re far more likely to be appropriately capitalized and because you see the value of it, you’ll also be more likely to adhere to your risk plan.

Let’s take a look at an example using the ES. A losing trade on a 2 lot in the ES and risking 2 points per trade, will cost a trader $200 (excluding fees & commissions). If the trader is willing to risk a maximum of 2% per trade of their starting account balance, they must deposit a minimum of $10,000 to trade this particular product and strategy.

Many people start with much less than this and therefore they risk end up risking a much greater percentage of their starting capital. Is it any wonder that so many traders struggle?

“Is it any wonder that so many traders struggle?”

Note: An important point here is to distinguish between the amount of risk per trade as a percentage of starting account capital and the amount of risk per trade as a percentage of current account capital. Ideally, a trader would have enough capital and therefore sizing flexibility to implement the latter, but this is often not realistic for traders with smaller accounts.

Undercapitalization2

There is another crippling side to undercapitalization, which often fails to be addressed.

Let’s say the trader does their homework and figures out, as in the example above, that they need $10,000 to trade 2 lots in the ES using a strategy that risks $200 per trade. They scrape together the money from savings and “loans” from family or friends.

It’s not ideal, but they have to if they want to trade – they only realistically have $250 per month of their income which they could use to supplement their trading capital. So it would take them 40 months to save the $10k they need!!

Because they cannot easily replace the money if it’s lost, they cannot afford to lose their account capital at all.

“Because they cannot easily replace the money if it’s lost, they cannot afford to lose their account capital at all”

If the money that you’re trading with is so important that you can’t afford to lose it, when you do encounter runs of poor performance, fear can take over. When fear takes over, you can’t trade properly.

Your Options to Overcome

If you do your sums as we’ve already looked at earlier and you find that you are indeed undercapitalized, what are your options going forward? Give up? Get a better job and earn more money to fund your trading? Get financially backed by someone who does have enough capital?

Maybe. But there are a few alternatives to consider first.

1. Reducing Risk per Trade

Reducing the number of ticks/pips you risk per trade is one option and many try this. The issue with this course of action is that although it’s important to optimize risk, tightening your stops up too much will lead them getting hit more frequently and a reduced win rate. But it is essential that you assess your strategy and how it fits in with the normal ebb and flow of the particular market you are trading.

Reducing the number of contracts you trade with is a good option. However, it’s not one that’s available for many traders. Most people starting out don’t have vast amounts of risk capital they are able and willing to lose. So people often start with enough capital to trade a 1 lot. This in itself has inherent problems and it’s likely to be easier for someone to trade with at least 2 or 3 lots.

The main issue here though, is that you can’t reduce your trade size any lower if you trade a 1 lot. If you can reduce the number of contracts you trade to bring your risk down to 2% or below, this is something that you’d be wise to consider.

If not, going to a smaller product such as a CFD or FX product, or finding a market with lower volatility can be another effective way to reduce you levels of risk per trade. If you do choose to trade a CFD or FX product, you should consider how the different execution may affect your performance. If you trade a less volatile market, consider whether it’s a good fit for your strategy (and of course, back-test it!)

In either case, finding the right product can be a critically important step towards fixing undercapitalization and trading success.

2. Protecting Your Equity Curve

Protecting your equity curve is essential to achieving trading success. By being clear on exactly what your setups are and what their historical-based risk is and adhering to your trade plan, your equity curve actually means something rather than being just a combination of the results of random trading.

One way to do this is to ensure you have defined risk limits. This can encompass the maximum amount you can lose per day before stopping, the maximum number of losing trades you can take in a row and of course, the maximum loss you can take per trade. Another aspect of risk limits is having daily profit targets and it’s quite important to consider.

Too much and you risk giving decent profits back. Too little and you risk cutting trading short when conditions are ripe for your strategy.

It’s also incredibly important when you’re trying to attain consistency, to make sure that you always take your setups accurately and never take setups outside of your plan. Taking questionable setups or setups outside of your trade plan, might seem like a good idea at the time, but unless you are thoroughly prepared for them there’s one huge danger – when they go wrong, the chimp within will go bananas!!

On top of this, you’ll render your equity curve meaningless (apart from telling you what your overall change in account capital is). Taking trades outside of your trade plan means that the results are a combination of strategies and you’ll not be able to know with any degree of accuracy, what the performance of each strategy has been.

If you do intend to trade multiple strategies, you must tag each trade with its strategy type in your trade log, RELIGIOUSLY!!

Finally, practice like hell!!

There’s nothing worse than seeing your equity curve take a dive because of either taking a trade by mistake or a fat finger error.

Make sure you know your trading strategy and trading platform like the back of your hand and that you can execute properly every time.

3. Find the Sweet Spot

Blindly trading a particular strategy without paying respecting that certain conditions are more conducive to it making money than others, is not good at the best of times. But when you’re sailing close to the wind with your levels of account capital, it can really hurt you.

It’s just as important to find the worst conditions as it is to find the best conditions. Avoiding trading blackspots can really help protect your account.

Be specific about when you trade.

There are plenty of ideas to consider in looking for the trading sweet spot for your strategy, but it’s usually best to start with getting the basics right. To begin with, you can look at how the performance of your strategy varies throughout different times of the day. You might find poor performance at lunchtime or better performance at the close than at the open, for example.

This might seem obvious, but finding the precise figures can help you to determine when you will and when you won’t trade.

It is important however, to consider two factors when looking at time of day performance. The first is that your trade log stats are not a good basis for this investigation. You might not trade the whole session and earlier trades are also likely to impact whether you take later ones or not. Manually back-test the strategy and in doing so, take every single valid trade. This will give you a better dataset to work with.

The second point is that big economic releases can really skew when a strategy works and when it doesn’t. Fortunately, it’s not too difficult to find historical economic calendars on the internet. Although the task is somewhat arduous, it is well worth doing in order to accurately complete this investigation.

Define the volatility you will trade.

Spikes in volatility are easy to see and a lot of traders with smaller accounts do recognize that there’s often the need to back off trading when markets are getting crazy. But it’s just as important to look at what the minimum level of volatility you require to achieve good strategy performance.

When you trade markets that are too quiet, many strategies don’t perform well. Again back-test your strategy and see how it fares.

Define the type of activity that you will trade.

It can also be very revealing to investigate what the performance of a strategy is, relative to what the market is doing. Some strategies do well when a market is balanced and some do well when a market is trending. But many don’t do well in all types of condition.

Imbalanced Market

Targeting the right conditions for your strategy can help to take it to the next level.

Undercapitalization is for Chimps

The psychology of undercapitalization means that fear and greed are often amplified. When you’re that much closer to failure because you just don’t have enough capital to trade what you want in the way you want to, it can be far more stressful.

The chimp within (i.e. the primal part of your brain) will take hold if it feels very uncomfortable and that it might be under threat. Emotions are then exaggerated and mistakes can be made. You, the human, are left with only guilt, regret and a big hole in your account! Excited chimps urge you to take extreme and often irrational action – not the sort of thing generally associated with successful trading!

“Excited chimps urge you to take extreme and often irrational action”

If you have a tendency to let your chimp mind get the better of you, it’s absolutely crucial for you to take full responsibility do all you can to mitigate the issue. Undercapitalization is often a big part of this problem.

For more updates from Mark and the team at NetPicks, be sure to visit their trading tips blog at NetPicks.com.