Deciding the Right Amount of Startup or Seed Capital

                          
OK, let’s start with one of the most important thing before you start trading: deciding how much capital to put in. Before I start showing a common method that is being used by many system traders, I would like to stress that this is just a guideline, there is no such thing as one size fit all rules to follow, just know your own strengths and weaknesses and adjust accordingly. The method here tends to be more conservative, therefore the return rate on startup account would be lower as well. Remember that it is always about finding the balance in trading; if you want to have a higher chance of surviving the worst drawdown, then you’ll have to start with more capital, but that in turn would limit your rate of return on startup capital.


As an example, let’s say you have decided to use my earlier example which is RSI 55/45 trend-following system to trade FKLI. You have done your statistical back-testing and obtain the following result (don’t worry, I’ll discuss the process of statistical back-testing on my following posts).

The first thing in this case that you’ll have to look at is the maximum drawdown near the bottom. It can be expressed as an amount or percentage. Since we’ll be deciding on the startup capital, we’ll look at the amount only. A drawdown is basically the amount of losses in your trading account from current peak level to the lowest point (valley) before the next peak. The maximum drawdown therefore is the largest drawdown from the back-testing period. That would represent the worst equity fall before your account goes up again.

If you look at the performance summary, there are two maximum drawdown values. First one is maximum closed drawdown and the other is maximum open (intraday) drawdown. Since this is a trend-following position-trade based on daily data, we’ll hold position overnight. Remember this is just trading 1 contract. The maximum close drawdown only measures the positions that have been closed whereas the maximum open drawdown takes into consideration the intraday worst point in your open position as well. Therefore the maximum open drawdown is usually larger than maximum close drawdown. Occasionally they may be the same if you close the position at the worst point but it can never be smaller.

What most beginners tend to forget is that the maximum open drawdown is more important if you are deciding on the worst case scenario. What we want is to find the level that will likely survive the worst drawdown and still above the worst case of margin set by the exchange for that product so that you don’t have to top up any more capital for margin call or risk your open position being liquidated by your broker. Of course systems sellers would definitely want you to be able to start with minimum capital therefore they will tend to focus on the maximum close drawdown. Just be sure you know the difference.

Now here comes the part that is most controversial and you’ll have to adjust to your personal objective. If you are a very optimistic person then you would probably believe that whatever period you have used in your back-testing is the worst that is going to be, then you can set your startup capital = maximum open drawdown + worst (highest) margin set by exchange. In this example you’ll need a minimum of RM 21,850 + RM 8,000 = RM 29,850. Remember this is the minimum amount trading only 1 contract and you are being very optimistic! How many retail speculator you know start trading FKLI with that amount and are discipline to trade only 1 contract?

Let’s say you have read Nassim Taleb’s Fooled by Randomness and The Black Swan, and still have the courage to trade, you would want to be more conservative in setting the level of startup capital. Most professionals and authors of books on systematic trading would recommend a safety margin or factor of 2 x maximum open drawdown (based on the belief that the worst is always in front of you). If you were to follow them, then the startup amount would be = (2 x RM 21,850) + RM 8,000 = RM 51,700. That would also take care of the slippage, rolls and commissions which is very often neglected by system sellers!  Now, how many do you think start with this amount using the particular RSI strategy and trade only 1 contract?  Ever wonder why most authors said only about less than 5% of winners in futures speculation? To make the matter worst, that drawdown is over 40% of your conservative startup capital! How many people can still believe in their systems and follow the signal on the next trade after suffering that amount of losses? They would tend to second guess and overwrite their systems by then.

To summarize things up, in order to know the right minimum amount of startup capital to trade, you’ll have to have a set of trading rules that represent clearly your trading strategy (that you’ll follow), otherwise there is no way of measuring accurately the amount of maximum open drawdown using your strategy. Then you’ll have to get a historical data that is correct and has all the different cycles of the market (I’ll go into that when I start posting on designing systems) and do a simulation of trades based on your trading rules. Calculate the lowest level (include intraday worst case) from current peak level of equity, then multiply that amount by 2 and add the highest margin ever set by the exchange for that product for that period and that is your MINIMUM capital to start trading. It is that simple!  You just have to find the balance point yourself.