One of the reasons many traders gravitate toward trading futures is the relatively low start-up cost. For example, it usually requires about $30,000 to open a stock day trading account and you must maintain at least $25,000 to keep your day trading status. The futures market allows you to open an account for as little as $5,000, and best of all, you do not have to maintain that amount. As long as you have sufficient cash in your account to cover the margin required to trade the commodity, you can actually have a balance of $700 - $800 and still trade futures. Margin is a percentage (usually 3-9%) of the full contract value.
We would all like to trade an account that has several thousands of dollars, but realistically, most traders have small accounts. These accounts are still tradable, but you must have strict risk management. Since you will be operating on a razor thin account size, you don’t have much room for mistakes or large losses. If you do have a small account of $2,000 and you suffer a large loss of $1,200, you might not have enough cash in your account to open another trade until you deposit more funds. When accounts are less than $1,000, most traders can only day trade until the account is larger.
When trading an undercapitalized account, you will find it much more difficult than trading a larger account. When your account has excess funds, you can build a buffer to help protect you against the inevitable mistakes and account drawdowns. Unfortunately, small accounts do not allow you this comfort level. Larger accounts also allow a trader to be more diversified and flexible in their market choices to trade. Another nice feature of a larger account is you can trade more contracts when the need arises. A small account might limit you to trading one contract, and when it comes time to exit your trade, it is harder to manage. Because of this, you are faced with the question, do I get out here or let the market run? Usually, this turns into an emotional decision for most traders, and they do not manage the trade well.
We are all aware of the psychological challenges facing traders, but a small account trader has even more obstacles. Traders with smaller accounts realize they cannot afford to lose much before they are not allowed to trade. Performance pressure will lead to costly errors. This could easily turn a trader into an upside down risk/reward trader. These types of traders usually start thinking that they will just take one or two ticks of profit and slowly build their accounts. Unfortunately, the market volatility does not allow them to place a protective stop that is in proportion to the reward. For example, you might see a trader risking $100 (about 8 ES ticks) trying to capture $25. Some traders can make this work for a short time, but eventually, the market goes against them and they will not exit the trade because they don’t want to lose all the hard-earned small profits. Soon the market takes back all the small profits, usually in one trade. You can see that risking $100 to make $25 is not a good risk/reward ratio. We try to find trades that allow us a chance to make $100 while risking maybe $30 – $35. Even large account traders will have drawdowns (losing streaks), but their account sizes allow them to continue trading without much added stress unlike a small account trader.
If you do have a small trading account, here is some help for you. I probably made it sound like small accounts cannot succeed at all in the futures markets. My intent was to make you aware of how much more care and selection you must put into your trading plan and decisions. Even after your account begins to grow, I would recommend that you take out any excess funds you don’t need in your account every month. This way you will not become careless and give back all your profits. An advantage of traders with small accounts is that they are aware of how close they are to not being able to trade. Therefore, they carefully plan and patiently wait for their trade setups unlike traders with too much money in their account who may take trades on a whim because they feel like they are playing with house money.
Trading futures is all about using leverage and this allows smaller accounts to participate more easily than cash accounts for buying stock. Even if the value of the futures contract you are trading is worth approximately $40,000, the trader will only need about $2,500 to manage a position that controls this $40,000. Keep in mind that leverage can cut both ways and losses can and do occur. Also, in futures trading, you can lose more money than the amount in your trading account unlike a cash account where your losses are limited to the amount you paid plus commissions.
When placing trades, make sure your strategy allows you at least a 1:3 risk/reward ratio. This conservative style trading will allow you to have one winner and then three losers before you are back to even again. Apply this rule to day and swing trades alike. Give the market time to reach your price targets and do not cut your profits short. Doing so will ultimately lead to losses taking away your profits much more quickly. Many traders have a hard time taking a loss and will let their losses run, or have too big of a stop for their account size. If a trader will use the 1% or 2% rule for risk management, they will be trading for a long time. If you use this rule, you will have to lose almost 100 times in a row for the 1% rule, or 50 times in a row for the 2% rule, before they wipe out their accounts. This is also another reason to have a trading plan because it makes you trade consistently. If you follow your plan, it is highly unlikely you will have 100 losses in a row. Most traders who do suffer these types of losses are the ones who change their trading style after every loss and lack consistency. Once your account begins to grow using these 1% & 2% loss rules, keep on using them regardless of the size of your account. By following them, you will have a much better chance of surviving futures trading.
For the number of contracts to trade, there are a couple of general rules you can use.
$10,000 per contract you trade
(Account balance * risk (.02) ) / largest loss = number of contracts to trade
If you use $10,000 per contract, then you will not be overleveraged trading. Once you can turn your first $10,000 into, say, $17,000, then you are ready to add another contract. Do not expect to double your account in the first year of trading. Many traders feel they should be able to do this. In all reality, you should be about break-even at the end of your first year. If you can do this, you will have a good chance of becoming a successful trader. Most new traders start out making money in their first few trades because they wait for their setups and then take the trade. Then after a few profits, they become impatient and trade every time a market moves. In trading, it is not how much you make; it is how much you keep that is important.
The formula above is the one I prefer because this will allow you to increase contract size as you become a better trader, and decrease it when you start to have drawdowns.
Let’s review what each of the terms mean in the formula:
Account balance = Trader's cash balance in their account.
Risk = This should be either 1% or 2% of your entire account balance.
Largest loss = Whatever your protective stop dollar value will be for this trade.
Number of contracts to trade = You may have to round this number up or down.
$25,000 * .02 divided by $125 = 4 contracts to trade
Keep in mind that this is your maximum number of contracts to trade and you do not have to trade this amount on every trade. If you are not feeling well, have computer problems, are distracted, or just not on your “A” game, then just trade a minimum number of contracts until you find a trade that justifies using your maximum contract size.
Do not be afraid to trade with a small trading account, but respect the rules we just discussed, build your account incrementally, and don’t look for home runs or lottery ticket wins.
A word of advice: You must work very hard on keeping your emotions under control with these smaller accounts. Make sure you have a well-written trading plan, and that you have confidence in your strategy and in yourself. Plan on this taking some time and do not expect overnight success.
Editor's note: This story by Don Dawson originally appeared on Online Trading Academy
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