This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com
I started researching investments and how to trade in 2003 after I started working professionally, when I quickly found my ignoramus college-graduate dreams of riches dashed against the rocky coastline of reality. (Who knew that I couldn’t drive a Porsche and have my own island on an engineer’s salary? And what’s with the whole soul-crushing corporate behemoth thing?) After I had recovered my faculties, I realized that if I were going to be financially free and independently wealthy, I’d have to learn how to do it myself. What better way than trading? Besides, I’m a “brilliant” engineer, right? (I actually AM a rocket scientist by degree, and a jet propulsion engineer by trade.) I could learn this whole trading thing better than all the other pinheads out there. I’d have it figured out quicker than you can say “second-order partial differential equation”!
Riiiiiight…
I went on a personal crusade to learn the ways of trading. Where to begin? Well, who’s the greatest investor? I started by learning fundamental analysis and value investing a la Warren Buffett. The whole thing makes sense, but you have to wait about 5 years to find out if you’re right or wrong! Maybe value investing is rational if you can avoid the duds, but I needed results now! Plus, I didn’t have any real capital to speak of.
On to short term trading: technical analysis, exotic indicators and tea leaves. I hopped from one methodology to the next, and this is what I discovered: Predictive TA is amazing—it usually works unless it doesn’t! Great; this is nothing like science and engineering, which are full of laws and absolutes. Time to try to learn by “doing”, I guess.
I opened a virtual stock trading account to start paper-err… computer-trading. I chased the daily % gainers and losers, bought some options, rolled the dice on earnings reports, and lost fake money; but hey, it’s just a simulation, right? I’d do better when it was for real. My intention was to fully learn how to trade profitably before going live, but in the end I couldn’t resist and opened an online discount brokerage account with $1000 that was burning a hole in my pocket. This wasn’t money that I needed to pay living expenses or anything, and if I lost it all nothing bad would really happen. But I wouldn’t lose it all—only an idiot would do that…
My first trade was AAPL, based on some iPod news release. If you bought the rumor and sold the news, you sold to me. Thanks. :-P I carved off about $300 as a prudent risk management measure (LOL) and bought a whopping 6 shares. I was sweating bullets on every tick: Red, green, red, green, green, red… After a few days I closed out the trade for an incredible $3.50 in profit. Easy Street here I come! That stellar result also included two free trades as a promotion for opening the account! Still, I had survived my first trade without “losing”, though I got lots of “loser practice” after that.
Fast forward to 2006: My account is down big time. On top of that, the brokerage executives are rolling around naked in a big pile of commission money, about $300 of which was mine. Eww. The traders who lived by the mantra “If you can’t see the other side of the trade, it’s you” saw the other side of my trades. So what happened? What was my downfall—diving in to manic stock rallies and getting left as the bagholder? Allowing a short-term trade to turn into a long-term investment, hoping to get bailed out? Trading options as cheap proxies for stocks? Technical or fundamental analysis errors? Poor stop selection leading to whipsaws? Mixing trade timeframes during the trade? Skipping from system to system? Widening my stop loss points after the trade went against me? Position sizing errors and crappy risk management? Revenge trading? Trading with Regulation T / Pattern Day Trader restrictions in force, limiting my options?
Actually, all of the above and more. I started out as a classic adrenaline-junkie knee-jerk mouse-clicking sucker, and thanks to many great teachers, I have now progressed to the point of understanding risk management, position sizing, expectancy, trade plans and rules, investor psychology and the importance of having an edge. I’ve learned that the first, early loss is the best loss, and to not only let winners run, but to add to them. I’ve learned that in the markets there are no absolutes, only probabilities. But even after learning these valuable lessons, I continued to make these same mistakes until I realized the underlying cause of all of the above symptoms. If you’re a neophyte trader, chances are it’s affecting you too. My fatal flaw? Undercapitalization! (I know, who woulda seen that coming…)
To my thinking, the big problem for those who want to learn how to actively trade comes from three incompatible things:
- To really learn trading, you have to have real money on the line or you’re missing some of the most important lessons.
- While you’re learning and you have no clue what you’re doing, you don’t want to lose your precious trading capital!
- Speaking of precious capital, if I already had a lot of money, I wouldn’t really need to trade to generate capital, would I?
No experience + no knowledge + no capital = no margin for error. Remember my AAPL trade? When you factor in my commissions, equity and position size, I would have had to make almost 5% on the trade just to break even! Can you say “Negative Expectancy”? Basically, as a noob trader I had to be right in a big way just to stay alive. Yeah, good luck with that.
So what can a beginner like me do? How do you learn how to be profitable and trade the right way with proper money management if you have to risk ~5% of your account just to cover commissions? Short answer: You can’t, so don’t even try. Seriously. As I found out, it doesn’t take a rocket scientist to pull it off—it takes a fortune teller! You’re better off paper trading, studying and saving up until you have enough capital to go live.
How do you tell if you “have enough”? Rule #1 of trading is to immediately bail if your trade is not proven correct within your timeframe and criteria. If the trade transaction costs are influencing your willingness to punch out of a bad trade, you’re undercapped. Without adequate funding, this will happen when you have a few losses in a row and you need a win to get your commission/equity ratio back down. If you’re in this situation, you’re dead. Realistically, if the amount you risk per trade (no more than 2% of your equity!) is not at least an order of magnitude (10x) bigger than your commissions, you need more capital.
Here’s an example calculation:
- Assume a $10 commission each way, for a $20 round trip
- Your ‘R’ value should be at least $200, or 10x the costs
- $200 is 2% of $10,000. That’s your minimum starting equity!
This can be reduced to a simple rule of thumb:
Your starting equity should be at least 1000x the cost of a one-way trade!
Most retail “discount” brokers with ~$10 commissions will let you open an account with only $1000! That can only end in brokerage executive moneypile-rolling. Gives the term “Naked Put” a whole new meaning…
There are deep discount brokers out there that let you trade for about a penny/share with a minimum of $1 per trade. With this structure you could get away with a $1000 starting account, as long as your trade size is 100 shares or less. (To their credit, some of these same outfits require you to start with even more money than that.) This is actually what I’m going to do next.
The bottom line: Find a broker that charges commissions that your equity can afford according to the 1000x rule. If there isn’t one, save your pennies before you even think about opening that account. Undercapitalized trading will only get you even further undercapitalized. Now that’s not rocket science.
This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com
November 30th, 2006 at 1:35 pm
Thanks for the article, ExEngineer! What a nice surprise. I’ve never thought about this before, because I always planned to be subject to the Pattern Day Trader $25k minimum rules. But, I can see how swing traders might try to start with too little capital.
November 30th, 2006 at 1:42 pm
From one engineer to another I can understand completely where you came from.
I figured if I can go through 4 years of engineering I can surely make it as a daytrader. I actually quit my job (believe it or not) to start daytrading without having any daytrading experience. I’m still trying to find my edge and every day I think I’m getting closer to being profitable (or going bankrupt).
I hope you don’t mind me asking, but are your gains consistent now ? If so, how long did it take you to reach that point ?
November 30th, 2006 at 2:03 pm
great article…i would only add one thing…if you open an account with ib or mb trading the commissions are minimal…you can trade with real money, and it doesn’t take much of a gain at all to cover the 5 cents per share cost
November 30th, 2006 at 2:09 pm
one more thing…if you practice by trading stocks with a larger handle (i.e., 40, 50, 100) then your commissions are lower thru ib or mb…if you are trading cheap stocks then the commissions could actually be more
November 30th, 2006 at 2:12 pm
@Richard: Thanks for the invitation to post on MTM! I’m working up to meeting the $25k pattern rule, but so far it hasn’t really affected me unless I’m actually trying to daytrade, and then I just have to keep it down to 3 trades per 5 business days. That can actually be a plus, as it puts a brake on overtrading.
@NoGreedNoFear: Congrats on making it in 4 years (I took 6.5 for a BS & MS). What flavor of engineering were you in?
I thought the same thing as you about quitting and going for it, but since I have several dependents, I haven’t quit yet. I’ve had to be a lot more conservative than I would like to be, in both time and money dedicated to trading. Hence the undercapitalization :(
As for consistency in results, I have consistently lost money up to the present, with a few wins sprinkled in. Thanks to money management, it has only been about -1R at a time, but my R level has been near 5-7% of my equity much of the time to get past the high commission drag. That’s way too high , and I’ve paid for it. Including commission, my trade history has about a -0.8R expectancy with about a 25% win rate. Not too good, but I’m looking at it as practice for my eventual full-time debut. I’d rather have nickel-and-dimed away a little account to learn some lessons than $1k-and-$2k’ed away a $50k account to learn the same things. I don’t really see a good bridge between paper and professional trading for the market student.
Anybody tried Zecco.com (a zero commission broker) now that it’s online?
November 30th, 2006 at 2:19 pm
@John: Thanks for the thoughts. IB requires a $5k account balance to start, while MB only requires $1k. I was thinking of moving to MB next–Anybody here ever traded with them?
November 30th, 2006 at 2:48 pm
Nice article ExEngineer! And as an ex-engineer myself, I can definitely relate.
November 30th, 2006 at 3:21 pm
@estocastica: Wow, are there any traders who are not ex-engineers? :) You folks are all my heroes for actually Ex-ing. Though it looks like I need a new name :/
November 30th, 2006 at 4:09 pm
ExEngineer,
Dump your high commission broker ASAP. I moved from e-trade ($9.95 each trade, so 20$ round trip) to lowtrades.com ($5/trade, $10 roundtrip) and finally to IB ($1 trade, $2 r/t). Believe me, those low commissions make it MUCH easier to be willing to dump a losing trade. If you need to have $5000 to open the IB account, find a way to get it! For proper trading, especially nowadays, commissions shouldn’t even be a factor. If they are, then you are needlessly complicating your trading.
Good luck to you.
November 30th, 2006 at 5:41 pm
“What flavor of engineering were you in?”
Electrical.
November 30th, 2006 at 7:13 pm
You damn ex-engineers! ;-) Add me to the list , I was an EE too.
Good article.
As an aside, am I the only one seeing all those weird characters in the post in place of apostrophes, etc.? That often happens when cutting & pasting between a PC document and a browser (WordPress entry form)
November 30th, 2006 at 7:21 pm
Mike: No, I see it too, and I did copy-and-paste just like you say. I’ll go back and edit…
…Looks like that fixed it! …Now it’s unfixed. :/ It looks okay in Internet Exploder, but not Firefox.
And for the record, Mike, you are one of the great teachers I referred to in the article. Thanks for all you do!
November 30th, 2006 at 7:43 pm
ditto.. Ex-EE… BSc, MS, PhD. trading is harder than all of them.
November 30th, 2006 at 9:31 pm
ex-engineer: i have traded with mb, and they are very good also…gl
November 30th, 2006 at 9:37 pm
Internet Exploder that’s rich (and what is with IE7, what a joke that is)! Anyways, what is the connection between ExEngineer and Richard. One guy is a pilot and the other an engineer, but are you the same person posting under different names, did I miss a meeting?
November 30th, 2006 at 11:33 pm
Bank of America is now offering 30 free online equity trades a month. I have no idea what their platform is like or reliability. But free is free.
November 30th, 2006 at 11:35 pm
ExEngineer,
Thanks for the article. It’s very educational.
December 1st, 2006 at 12:15 am
Hey! Have you been reading my mail? Your experience is almost exactly the same as mine, only I started out with $25000 and I am now down to about $3500. With margin I have about
$10500 trading capital, and I am becoming a much better trader and a hell of a lot more disciplined.The initiation fees in this business are rather expensive,but as a friend once told me:”The pain will drive you to the
solution”.By the way I am also an engineer,
a locomotive engineer. Thanks for your honesty.
December 1st, 2006 at 1:25 am
@Gordo… um… I am Richard, an ex-engineer myself. ExEngineer is a current engineer who hopes to be an ex-engineer one day. Zoomie is the ex-pilot. We are all different people.
December 1st, 2006 at 1:36 am
I think I fixed all the unusual character artifacts. Lemme know if any persist for you. Yeah, cutting and pasting + smart quotes does not work out. I also turned the ordered lists and bullet list into html lists.
The version of Wordpress I use has a bug that adds slashes before quotes on edited comments, as you can see from one of the comments above. I think I will try to upgrade wordpress tonight.
edit: Ok, I’ve upgraded wordress. Hopefully everything is okay, still. (And, I fixed that comment above with the wordpress-bug unnatural slashes).
December 1st, 2006 at 2:56 am
hi,
i agree absolutly…a possible solution might be: have you ever considered trading currencys ? take for example oanda (www.oanda.com), they have NO commision, NO minimum trade size, you only pay the spread, they offer a 50:1 leverage, means, with a 1000usd cash acc you can trade up to 50000usd in position value…what ? you dont know nothing about currencys ?…doesnt matter, markets are markets, not ?
December 1st, 2006 at 6:54 am
@Richard:
“@Gordo… um… I am Richard, an ex-engineer myself. ExEngineer is a current engineer who hopes to be an ex-engineer one day. Zoomie is the ex-pilot. We are all different people.”
Okay, now I’M confused! We’re all ex’s, but ‘ExEngineer’ is the only one here that really ISN’T an ex, Richard’s got an “Ex”, and the real question: where does Trader X fit into all of this? He’s not an ex-trader, but he really is Trader X…
December 1st, 2006 at 6:58 am
I feel out of place with all of these engineers in the house. I am an ex-mortgage company principal.
I am now a full time successful trader (9yrs)……..but have paid my fair share of tuition over the years to make it this far, and still do from time to time.
Nice to see others share their experiences.
December 1st, 2006 at 7:28 am
I’m the ugly duckling (no offense, Ugly) being only an ex-programmer. I only got to blow up corporate expense accounts but no rockets. :(
The writing is great stuff. I’m intrigued by these “tea leaves” you speak of - how are they working out for you?
December 1st, 2006 at 7:54 am
@Tyro: I used to study every kind of technical indicator you can imagine, but in the end I’m moving more toward the study of the actual price action itself. Trying to read something into indicator patterns is not much different to me than trading by astrology or even reading tea leaves. Simply following the rules of immediately closing a position that does not prove to be correct, and adding sensibly to positions that do will do more for you than all the oscillators in the world. Now, this is not to say that indicators and charts are not valuable in hindsight analysis, but trying to predict future price action from them is like reading a history book to find tomorrow’s news headlines.
This is all in my very limited experience. If anyone else sees this differently, I’d love to be enlightened!
December 1st, 2006 at 8:09 am
@Tyro: I’m also in the IT field. Looks like everybody comes from the matematika background.
@Zen-trader: I also started this month with a $7.5K capital. It is now up to $13K as of last night. Just taking small steps to rebuild my capital.
December 1st, 2006 at 8:18 am
@Tyro,
I guess I’m a hybrid. Although I got my degree in EE, I never worked as one after graduating. I went into IT / programming… it’s pretty much the same mindset though.
December 1st, 2006 at 7:01 pm
Its the curse of many to be stuck with took little money to work with. I took a stab at some number crunching to investigate some of the outcomes. Its a quick-and-dirty piece:
http://blog.fallondpicks.com/2006/12/low-capital-investing.html
Best wishes,
DJF
December 1st, 2006 at 9:39 pm
Hi Ex eigineer,
Great article. I had an accident in the may sell off this year and my account got clipped for about 6% of it’s value. That may not sound like a lot but it was the second most I had ever lost on a trade. I was able to make it all back over the next 5 months however instead of doing really well this year my account will close slightly positive if things ended today. I really learned how important 1 position sizing is 2. money management is 3. Having an exit stategy before you put the trade on. As an aside I have been using IB and I have been really happy.
December 1st, 2006 at 11:49 pm
Great article. I have one more thing to add. I quitted my (accounting) job and started trading at home for 3 months now and have been doing fine.
When I looked back, so many times that I had to double and triple my initial investment to lower my cost or sell options and tied up my investment to breakeven (in order to return to profit. I had been lucky and will work on my risk management).
I learned the hard way as one day in November that my margin balance reach maximum and cannot trade anymore.
In addition, I read from a blog on calculating the true return. You should consider your lost salaries, inflation and “normal” return on you investment. You can also back calculate what your capital should be by reverse the calculation by you average trading return.
For example, you earned $50k per yeas, and inflation is 3% and you return on investment is 11%. With $100k capital, you will need 64% to breakeven. There is $50k salary+$2K inflation+$11K return. However, if you have $200K capital, the 200K capital, the return will be dropped to 39%. So take a look at your past returns and see if you should continue tradnig or take a job.
December 2nd, 2006 at 9:38 am
Drop your account and move to Interactive Brokers. IB has min 1 USD per stock transaction and 0.50 USD per option contract. You can’t get any cheaper. Though, if you want to daytrade you need min 25,0000 USD. At least for US equities.
I use IB all the time and think it is one of the best brokers in the market.
December 3rd, 2006 at 9:04 pm
[...] Absolutely spot on. If you’re going to do it, do it right! [...]
December 22nd, 2006 at 10:09 am
[...] This trade brought to you in part by Zecco Trading, helping undercapitalized n00bs learn the ropes since 2006. Stocks Mentioned In This ArticleStockLinks ONSM | | [...]
January 4th, 2007 at 3:37 pm
[...] I’ve had 4 wins in a row now! I’m trying not to let me head get too big as I count all the loot. :-P I used to be so frustrated with my trading, and I thought the biggest problem was me. Since Zecco, it seems to have been my undercapitalization in the face of 2% of account equity commissions that were my failing point. We’ll see if that trend continues, but it’s very encouraging for my eventual full-time trading debut (fully capitalized, of course)! Before then, I really need to document the trading plans, systems and rules that are mostly in my head, learned mostly from the great bloggers out there, many of which are on Richard’s “Blogs I Read”. Stocks Mentioned In This ArticleStockLinks BTU | | [...]
January 17th, 2007 at 9:44 am
[...] There is one important corollary that needs to be pointed out. My modified analogy above also serves to highlight the problems of being undercapitalized (which Prospectus also discussed here) - the smaller your account size, the slower and harder it is to grow your capital. This is because the size of your wins are relatively smaller. A 3R win on a 30k account (with R=1% of account size) means a 30R win on a 3K account size (with the same R=1%) - and how often will you experience a 30R win from a single trade? Right, so one subtle (yet important) corollary of this snowball fight analogy is that one of the requirements for entering the business of Trading for A Living is having sufficient account capital. [...]
March 3rd, 2007 at 12:36 pm
[...] an aside, I opened an account with Zecco, which has solved my undercapitalization problems with their offer of $0 commissions. My maximum risk for this trade was $15, or 2% of my [...]