5 Principles for Trading with a small account.

Trading for a living is fundamentally different from retirement investing, or trading for supplemental-income.  There’s actually a little bit of pressure that goes along with attempting to make your living from trading, especially if you’re not starting with a huge wad of cash.  So if you want to trade for a living, and you don’t have a gazillion dollars to fund your account with, read on to learn a few of the principles that I have used in order to make, and sustain a decent living trading currency.

#1: Take Profit

That’s what trading is all about.  Period.  Taking profit.  You’re not losing money by taking profit.  Your account is not big enough to absorb and sustain drawdown, yet you’re trying to pay bills so you’ve got to get paid.  At this point, the direction your account balance moves is of much greater importance than the speed at which it changes.  Not to mention, there’s some unbreakable and unwritten law of trading that says when your account balance goes down, it drops much faster than you can make it go up.  Don’t test this theory, accept it and let it put the fear of God into you.  The idea is to quit while you’re ahead, every time you get ahead.  Do not concern yourself with how far ahead.  Taking less profit more, results in more profit.

When your balance has grown to something more substantial, you can endorse concepts like “let your winners run”.  For now however, you just can’t.  Doing so will cost you dearly.  There’s nothing wrong with the idea that the vast majority of your trades are closed at break-even or just slightly above.  In fact, with a small account this is desirable.  You’re taking trades, but not losing money.  I’m a huge fan of 10 pips.  I’m a bigger fan of 5 pips.  2 pips will do nicely as well. A pip in the books is a pip earned.   A hundred pips in open PnL is worthless until you take it.  Your chances of success go up proportionally to the age of your account.  Every day, month, year that you trade without losing your account increases the chances that you’ll end up where you want to be.

#2: Size Matters

Trade size.  What a debatable topic. Everything is relative.  The viability of your “system” is relative to your capacity to implement it properly.  The amount of income your pips represent is relative to your trade size.  With a small account and a “must-produce” scenario, a constant trade size relative to account balance simply does not work over the long haul.  At least not with the degree of efficiency required to pay the bills, leading instead to step-forward/step-backward, sideways behavior in your account. Don’t get me wrong, I’m not advocating trading as big as you can, this destroys accounts.  I am saying however, that you’re not going to pay many bills trading micro-lots.  This goes hand in hand with #1 above.  If you put a couple of standard lots on a trade with a $5k account, you had better be taking profit quickly.  Margin Calls suck.  If you are intent on 20 pips, 50 pips or more, then your size needs to be much smaller than you want it to be.  A mini-lot for every $10k in your account.  This will definitely grow your account, but not if you need to pay bills with it.

#3: Do something else

90% of a day trader’s day is spent NOT trading.  You need a finish line, every day.  Whether you make money, lose money, or break even, there must come a time every day when you are finished.  Don’t trade because the market is open and you want to make money, trade because an opportunity that you are prepared to capitalize on has presented itself.  These are fewer and further between than most people think.  You’re undercapitalized and over-leveraged.  In this situation, an impulsive trade is like arming a nuclear bomb in your trading account.  There will be no recovery after it blows.

A higher level of risk has been assumed by trading larger relative to your account balance than anyone ought to feel comfortable with.  This elevated risk must be offset as much as possible by a) reducing the trades you take to only the absolute most probable to succeed, and b) limiting exposure time in the market. If you’ve been between 2 and 5 pips in profit for an hour, CLOSE the trade.  You’re finished.

One of the things I love most about trading, is all the glorious time off.  Your reward for doing a good job, is to take the rest of the day off.  Your punishment for screwing up, is to take the rest of the day off.

Seriously, how awesome is that? Maybe it’s awesome, but it can also be very hard for some traders to accept.  For some, the “call of the charts” is powerful and the opportunities they present quite difficult to resist.  Know and understand however, that resisting the urge to trade constantly is one of the skills that will make you tons of money.

#4: Deny loss

When your stop loss gets hit, it’s over.  That is a loss, and nothing can be done to mitigate its effect on your capital.  As capital declines, so does the efficiency with which you can recoup the loss.  Only in very rare occasions do I use a stop loss, and even then it’s usually an in-the-money stop.  My prevailing viewpoint is that if I feel the need to have a stop loss, then my level of conviction in the trade is not high enough to warrant taking it.  Stops can create a false sense of security in the trader, implying that “it’s ok to lose this much money”.  It is not.  Trading without stops promotes increased selectiveness and more thorough planning.  Just because there’s no stop, does NOT mean you don’t need to plan and prepare for a trade to go the wrong way.  Your job is not to be right, it is to be profitable.  While being right tends to make profit a little easier to realize, it’s just as easy to lose money when you’re right, especially with a small account and stop losses.

When a trade goes bad, there are options.  Options that can save the money this trade is putting at risk.

Roll it over.  The very first thing to determine, is whether or not you’re actually wrong, or if it just looks that way at the moment.  Could you be early?  Adding to a losing position is not the cardinal sin we are led to believe.  Sometimes it’s just foolish, but skill in this regard can not only save you thousands in losses, but also earn you incredible profit.

Hedge it up.  Hedging allows you to stop the bleeding and assess the situation calmly without actually taking the hit to your account.  Often times both positions can eventually be closed in profit.  US traders cannot hedge directly in the same account, but you can certainly open a trade in the opposite direction in another account, or use a proxy-instrument as a “soft-hedge”.

Wash it clean.  You’re carrying a loss that’s out of hand.  It’s not coming back, or if it is it’s just too long from now and you’re account can’t deal with it.  If you’re not subject to FIFO regulations, washing is a rather simple affair.  Hedge the trade and begin trading “inside” the loss.  Take small trades and tiny profit.  Each time you take profit “inside” this loss, close a portion of the original trade that is equal to the profit.  Consider the following as a quick example:

1st trade 1 standard lot goes negative.
2nd trade 1 standard lot opposite direction – You hedge it at -10 pips for a running drawdown of -$100.

Now the washing begins.  The idea is to make $100 before closing both of the above trades.

Wash: 3rd trade .5 lots, profit taken at 5 pips for $25.
Rinse: Close .25 lots of the original position and the hedge for a loss of $25.  You have just washed 25% of your bad trade.
Repeat: do this 3 more times and you’re back to even.

Why not just close the position in the first place?  Well, maybe you should.  If you’re stuck with FIFO you’re going to have to.  In this case you’re going to have to earn every dime you lost at the time the trade closed back before you’re even.  Washing as described above though, keeps the loss capped while at the same time giving the original trade time retreat closer to your opening price.  While not guaranteed, this means it’s possible for the amount you must wash to shrink while you’re washing it.

The bottom line is that you cannot afford to accept defeat.  Unexpected consequences bring unexpected opportunities.  Keep your eyes peeled for these when things go wrong, and no matter what, keep calm.  Only action can help you, reaction will tend to make things worse.  If you don’t think you can calmly handle things like adding to a loser, or washing trades, then it is paramount that you avoid these activities and simply close trades before they can get away from you.  Often times though, just knowing there are options is enough to make the situation a little easier to handle.

#5: The Kung Fu of it all

At some point, we all want trading to be a “paint by numbers” endeavor.  It simply is not.  Trading is rife with subjectivity, and markets behave irrationally all the time.  At its very core trading is somewhat counter-intuitive and in any case, an argument for any other case may be made.  To succeed at this, you’re going to have to break the rules at times.  You’ll need to discard conventional trading “wisdom” and all-to-familiar platitudes at the door.  You’ll need to do it differently than everyone else, most of them are losing money.  Sometimes it’s easy.  Sometimes it is excruciatingly difficult and painful.  Sometimes it’s pointless to argue with your chart, and sometimes it’s your gut you can’t ignore.

Good Kung Fu (and trading) requires harmony and balance in all things.  Your trade size must be in harmony with your available capital as well as your profit target.  Your dedication to following rules must be balanced with a willingness to break them.  Your opponent cannot be knocked out.  Understand that you must break him over the duration of the bout with well-placed and perfectly timed jabs. Search for weak spots and then go to work on them.  When you find something that works, put a lever on it.  When the market counters your moves, it’s up to you to counter the counter.  Don’t complicate your existence.  During this account-building phase, live simply.  It is always easier to spend less than to make more.  Also work simply.  You’ll need to put considerable effort into keeping your trading as simple as possible.  If you’re relying on 39 indicators and a math equation that crashes any computer more than 2 months old for a 5 pip trade, well, you’re toast.

Above all, you must remain realistic with regard to your trading.  If you have expectations, trust me, they’re unrealistic.  Throw them out.  Don’t expect to make a lot of money, or lose a lot of money.  Don’t expect things to be easy, don’t expect them to be hard.  Expect them to simply be.  When they do get hard, when things go bad, quit.  Be done for the day.  Or week, it doesn’t matter.  You cannot allow trading to grind on you, to wear you down, because it can literally wear you out.

Kung Fu is dynamic, fluid and highly adaptable.  The trader must also be dynamic and adaptable.  Remember that everything is relative.  As your account grows, you must also adapt your trading to remain in harmony with your growing balance.  You can’t trade a $100k account the same as a $5k account, and you certainly can’t do the reverse.  As your account grows, you will want to decrease risk relative to your equity.  You’ll have the opportunity to broaden your approach to trading, and employ more quantifiable strategies.  You can put on some longer-term trades and begin looking for bigger rewards.

You don’t even have to be good at this to grow a small account into a big one.  You just need a good set of symbiotic principles to guide you through a repeatable process of accumulation.  Growth is a side-effect.

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28 thoughts on “5 Principles for Trading with a small account.

  1. Desmond Cheah WK (@DezCheah)

    Mate.. I been trading for a living for 4 months.. you spoke of many things that I have faced.. Point 1 and Point 4 were really what I lack.. It would have help me kept my account if I had remember those 2 principles.. I will give it a try again.. with those points you have shared.. hopefully to be successful this time round.. Thanks..
    -DC

    Reply
  2. fxoutlier

    Great post, it’s been so long since the last. Got to get my head around this hedging and wash and rinse stuff though, as I have with Shonn’s inventory management. Look forwards to more on all this. Thanks.

    Reply
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  5. Bob

    Great post and great points all around ! Of particular interest is the wash, rinse, repeat hedge approach. This deserves its own dedicated post to explore further. What happens when your trade within the hedged trades goes bad ? Close it quickly or hedge inside the hedge ? Could turn into a large mass of longs and shorts. If you have say a 75% win rate and you need 4 successful trades to dehedge then 1 will go the wrong way.

    Reply
    1. mlacoco54 Post author

      Washing losses is definitely not for everyone, and should be viewed as a mechanism by which the trader stays on task, as opposed to trying to hit a grand slam by increasing risk. As you point out, this concept most assuredly does increase risk. As far as a wash trade going bad, there should be ZERO tolerance for letting it go bad.

      What happens to a traders 75% win rate when the profit target is lowered by 80% (or some other dramatic figure)? It’s impossible to know how many trades it will take to wash a loss. Does it come back a bit? Is it still going to take four trades to get out after the first two? We can’t know before hand. Again, the idea is that it keeps us on task, we don’t go looking for more of our regular trades, until we’ve erased the loss, or brought it to an acceptable value. One must also consider the transaction costs associated with washing. They can add up considerably, to an extent that getting the original trade back to break even is not sufficient to ensure we don’t lose money.

      Reply
      1. Bob

        Agreed, I have been using a similar method and trying to optimize the secondary trades and iron out the parameters to make it overall successful. Work in progress…but shows much promise.

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  7. Henry

    I just ran across this post and have read it several times. It is one of the best, most transparently honest posts about trading a small account (or any account) I have ever read on any trading blog or trading book. It helps that it’s written in flawless English that’s a pleasure to read (as opposed to usual malapropism-laced and spelling-challenged trading blogs). But mostly it’s because it isn’t afraid to attack the sacred cow convention wisdoms peddled by traders with million-dollar accounts. I’m going to start using your blog tagline (“Not a trader, just do it for the money.”) as a motto for the way I approach my life, of which trading is but a part. One of the worst things I ever did for my account was approach trading thinking that I was a “full-time day trader.”

    Reply
    1. mlacoco54 Post author

      Hi Henry,

      One of the things I discovered about trading, is that very little of the “theory” we learn from reading on the subject, actually translates to real world buying or selling. It either just doesn’t work in the long run, or it’s simply not compatible with the common human psyche.

      Thank you for the kind words, I will endeavor to not disappoint in the future! Please feel free to contact me anytime to chat about “real life” trading (or anything else for that matter)!

      Reply
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  9. Anatoliy

    Hi Matt,

    I must say, reading this post first time around I was quite confused, as #1, #2 and #4 did not ring true to me (yes, I trade long term, following boring, old school advice, trying to “be right and sit tight” 🙂 ). Then reading it again (and again) I saw your point much better – you are talking about trading a small account ($5K I assume) and trading it for living, paying the bills of the profits. It is certainly a very big challenge as one would have to make at least 30-40% a month just to cover basic living expenses and even then it would be hard to grow the account.

    When you look at it, I don’t believe it is a good idea to leave day job with no savings, no other source of income, and trust in one’s ability to consistently profit with a very small account. I think your advice will work very well for experienced short term traders, who have a very good feel for price action and still working their day job (even if just part time). Another option is having a wife (husband) who has A LOT of trust in you and works a day job. 😉

    My favorite is #3 – this alone can improve anyone’s trading. #4 though has to be applied with extreme care when you know what you are doing – I personally would not be able to do it (I know, because I tried…). I don’t deny a single loss, I enjoy paying the market for showing me the correct direction. When listening to what it has to say, it usually pays back pretty soon.

    Overall thank you for a great post and a different perspective.

    Reply
  10. Sergio Santos

    Still powerful advices. So important. So true.
    I wish I had read it before my last margin call ;). But now it’s time to apply another Kung Fu rule: stand up and fight again.
    Thanks Matt for your wisdom and thanks Robb Booker for remembering us this awesome post.

    Reply
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