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IT’S NOT AS SIMPLE AS:  “IT TAKES MONEY TO MAKE MONEY”

This gets asked a lot by new traders.  A common saying is “it takes money to make money.” While there is some truth to that, it’s not quite so simple.

A good way to determine how much money you realistically need in a trading account, is to examine several critical questions:

  1. What type of product will you trade?
  2. How much risk will you be taking?
  3. What are your financial goals?

What type of product will you trade?

This is easily overlooked by beginners who might not even know how many choices a trader has these days.  Most are probably familiar with trading shares of their favorite companies. They may not realize that there are also ETFs (Exchange Traded Funds), Futures, Options, ForEx (Foreign Exchange), and more.

This matters because different trading vehicles require different amounts of capital.  Stocks for example are the “worst” in that they generally require the full cash amount of the purchase.  If you want to buy 100 shares of a stock that is at $25 per share, you would need to have at least $2500 in your account (plus commissions, of course).  Note that I’m ignoring margin trading for purposes of this post.

Futures

Futures are by definition leveraged instruments.  What this means is that you only need to place a small deposit to place a large trade.  What you actually control is worth more than the deposit you place. Sometimes much, much more. . . For example if you traded 1 contract (the smallest amount you can trade in futures) of the S&P 500, known as the “E-mini,” you would be controlling an asset worth about $129,000 at the time of this writing.  However you would only have to put up between about $500 and $6,000 depending on your broker’s requirements.  Thus a small amount of money controls a very large amount, which is the basis of leverage.

Stock Options

Stock options control a larger asset than you are paying for, but in a slightly different way.  There are many varieties of options that can be traded, but the most popular ones control 100 shares of a stock. This is called the “underlying.” only for a small cost.  For example you might be able to buy an option which allows you to control 100 shares of XYZ stock. Let’s say XYZ is currently trading at $50. Therefore the real value of the asset you control would be $50 x 100, or $5,000 for a price of only $200. The big catch with options is that they expire at a future date. You need to be aware of that.  In this example $200 is controlling $5,000 worth of asset, so again you are employing leverage.

Forex

Forex is trading in foreign currencies. This is another type of product that employs leverage similar to futures. Forex can have incredibly high amounts of leverage, in some cases as high as 400:1. So every $1 invested would control $400 in assets.  This can be especially useful for small traders, but can also wipe them out quickly if they aren’t careful.

 

 

 

Leverage is especially useful if you don’t have a large account to start with.  Perhaps you only have $2,000 with which to begin your trading career. You could trade 1 contract of various futures products, or trade maybe a few options contracts, or get your feet wet in Forex.  But stock trading would be difficult unless you traded only very low priced stocks.  Even then you would need to beware of commissions charged by your broker because they could be a high percentage of your total account.

How much risk will you be taking?

There is a concept called Position Sizing which is a mathematical formula that determines how much money you can trade, based on how much you are willing to risk. Nobody enjoys losing money, but some losses are always going to happen to even the best traders. They need to determine up front how large they are willing to let those losses be. A good general rule to follow is: no more than 2% of your account should ever be at risk (less is even better).

Example:

That means if you had a $20,000 account, you would only be willing to lose $400 (2% of your account) in a trade.  If your trade lost that much, you would close it and accept the loss.  This way no single trade can wipe out your account.

The other piece of information required in this formula, is the actual dollar amount of risk in our specific trade. This means we have to decide up front how much we are willing to lose if we are wrong. Say we buy stock of company ABC at $20.  Then we decide we will exit the trade if it falls to $18.25.  That’s a $1.75 risk, or about 9% of $20.  If we know we can only risk up to 2% of our account on any one trade, then we can determine how many shares we are allowed to trade, with the following formula:

Account Risk Amount (in $) / Per-Trade Risk (in $) = Position size in shares

To continue this example: $400 / $1.75 = 228.47 shares

In this case, we can only trade a maximum of 228 shares. Always round down to the nearest even number. Stay safe with our risk parameters. If we buy our 228 shares at $20, and we are wrong on the trade and it drops to $18.25, then we will have hit our maximum allowable loss of $400. Therefore we will close the trade and move on.

 

 

 

By using the position sizing formula, we can determine how much money we will realistically need to have in our account. In this example, we would have to have about $5,000 in the trading account, in order to make the trade.  Obviously with a smaller sized account like this, we will probably want to focus more on lower priced assets. An alternative is to use leverage on other products, as previously discussed.

What are your financial goals?

If you have a goal of being a millionaire trader overnight, you may want to rethink your targets. Trading is all about making steady, consistent gains and growing your account. This happens over time, and you should not fall into with a “get rich quick” mindset. That being said, it is mathematically feasible to generate returns of 10% per month, even on a small account. Over time your account can grow, and the results compound.  A $10,000 account compounding at 10% per month, would turn into around $30,000 after one year with no withdrawals and consistent trading performance over that time.

The Bottom Line

As you can probably see, there isn’t a perfect one-size-fits-all answer to the question of how much money you need to start trading. Will you be day trading or will you be holding for long term investments?  How risk tolerant are you? How much money do you expect to make?

It is possible to open accounts with some brokerages with extremely small amounts of money – even just a few dollars.  But to be realistic a trader would be wise to start with at least $1,000 to $5,000 to take a moderate number of trades and learn to trade with consistency.

 

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