From the April 01, 2012 issue of Futures Magazine • Subscribe!

How much trading capital is enough?

Spread the risk

In the context of money management and risk control, we must consider diversification. Diversification spreads risk and reduces the capital needed on a portfolio basis.

We can demonstrate by returning to our spreadsheet and adding a fourth column. In this column, we add the values of the hypothetical trade result columns. The sum will range from zero to three. If it’s zero, we lost in all three markets. If it’s three, we won in all three markets. If it’s two, we lost one and won two. If it’s one, we lost two and won one. The results again are as expected. We have 126 zeros (out of 1,000 trades) in the fourth column. That is about 75% fewer zeros in any of the other three columns.

This is significant because if we lost on two trades ($1,000 x 2 = $2,000) and won on the other ($2,000 x 1 = $2,000), we broke even. If we lost on one trade and won on two, we made $3,000. If we won on all three, we made $6,000. The only losing situation is if we lose on all three trades on that particular row.

In the 1,000 trades, the longest string of losers on a portfolio basis is two. So, by trading three contracts with a 50% win and a two-to-one win-to-loss ratio, we reduce the longest string of losses by 75%.

With regard to final allocation estimates, if you intend to trade one contract, you should start with enough funds to sustain eight consecutive losses — plus the money necessary to margin the ninth trade. That is probably as much as five times what most traders allocate, assuming they only need to cover the initial margin.

If you incorporate diversification into your strategy, you can reduce the amount needed to cover the losing trades. If there were no diversification benefit, we would need to cover eight consecutive losses on each, plus the margin for the ninth trade, or $30,000. However, operating under the assumption that we can decrease the worst-case loss sequence by 75% through diversification, we can reduce the amount allocated to trade losses to just $6,000 (plus another $6,000 to cover the margin for all three markets on the next trade).

A word of caution: The real world will not necessarily match this idealized scenario. Although our tests have suggested a more conservative approach than most beginning traders adopt, going further would be prudent. Perhaps a starting contribution of twice the portfolio loss estimate ($12,000) plus the $6,000 margin requirement would be better.

One thing trading futures for 40 years teaches you: Traders have a hard time curbing their expectations. Leverage is the appeal that draws most of us in, and it is that attraction that causes many to flounder. With careful risk control and money management, you can make significant returns on your account. However, if you over-leverage and neglect trade structure for the latest “sure-thing” entry trigger, you undoubtedly will lose.

Joseph Stuber began his career in 1972 as a research analyst. He is an author and lifelong student of risk and risk management.

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About the Author

Joseph Stuber began his career in 1972 as a research analyst. He is an author and lifelong student of risk and risk management.

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