Looking at initial system capital requirements
Posted by John Forman in Pips Weigh In, tags: 50:1 leverage, CFTC regulations, drawdowns, margin requirements
The other day I had a reader of my blog leave a comment to my post on the new CTFC margin rules. My contention is that for the vast majority of traders, the 50:1 leverage cap (2% required margin) for trading the major currencies is more than adequate. The commenter left the following in response:
I’m actually kind of at a disadvantage with 2% margin requirements because that means that I have to have around $18,000 in my account just to be able to buy my 6 standard lots of GBPJPY which I need to be able to do as part of my trading plan. With 1% margin, I only need $9,000. If my trading plan calls for an initial capital of $25,000 plus the cost of entry, I can earn a much bigger percentage return on $34,000, than on $43,000 trading the exact same way. With the new requirements, the initial capital needs to be more and it becomes harder to show superstar returns.
In doing some follow-up I’ve learned that this trader basically looks at the $25,000 initial capital as his cushion against drawdown. He’s back-tested his system and observed it’s only seen anything close to that kind of drawdown a handful of times over 10 years worth of data. It’s good to hear he’s done that sort of testing.
Personally, though, I would take any drawdown seen in testing and double it when looking at capital requirements. That may sound very conservative, and perhaps it is, but I’ve been around the block enough times to know that the market always seems to do something different or more extremely than it ever did before every once in a while.
Now, getting back to the concerns about the impact of the 2% margin requirement vs. 1%, I think there are a couple of points worth making.
First, the rate of return difference will virtually disappear over time. Let’s say the system makes $20k in profits the first year. That’s about 59% on the $34k assumed as starting capital under the 1% margin requirement, 47% on the $43k when using 2% margin. Now say the system makes another $20k the second year. The 1% margin scenario would have $54k to start, so the return would be 37%. The 2% margin scenario would have $63k to start, so the return would be 32%. Notice how the spread between the returns dropped from 12% to 5% in only one year’s time? It will increasingly narrow until it becomes virtually nil – and the higher the rates of return seen each year, the faster the narrowing will take place. In other words, it’s not something I’d be concerned with.
Second, it’s one thing to say you’re comfortable riding out a big drawdown and a whole other thing to actually do it. That’s the sort of thing that’s easy to be rational about when testing, but becomes very emotional when it’s happening in real life. If this trader were to see his whole cushion wiped out by a system drawdown, we’d be talking about more than a 70% loss. Even going with the 2% margin requirement capital base you’re over 50%. That’s a hard thing to deal with for a great many folks. All sorts of questions start arising in one’s head about whether the system is broken.
The last thing I’d toss out there is the question of position sizing. This trader says trades up to 6 full lots of GBP/JPY in a throw, and it looks like a scale in from a starting position of 2 lots. Has he tested the impact of determining his position size relative to his equity base – which may require trading mini lots rather than standard ones – rather than fixed trade sizes? Depending on the system, there can be a major difference in performance. The relative trade sizing tends to lessen the depth of drawdowns because it reduces trade size as equity falls, but that approach can also be slower to recover to recover from drawdowns because of the smaller relative position sizes. Whether that works out for the best or not tends to depend on how drawdowns happen in the system.
Just a few things to think about.
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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results.
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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.
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My original trading system worked wonders in “tests” with over an 80% return, but when I employed it with real money, and unfortunately hit a streak of losing trades to start, I had a hard time maintaining my sanity watching my account dwindle.
In the end, I reworked my entire approach and was much better able to manage my risk and percentage of winning trades and I am much happier for it.
I believe if someone is trading with any amount less than $50,000 at a MINIMUM, they should be trading with mini lots, not standard lots.
Thank you John for your insights above.
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