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You must first have a view on the underlying and decide whether to set up an option or a futures position. Then, you must decide on the position size of your trade. This is based on your trading capital. This week, we discuss how to determine the size of your trading capital.
Trading system
Your initial capital can be determined based on your trading process. Nondiscretionary trading refers to trading based on automated signals- a system you design after rigorous back testing that will automatically throw buy and sell signals for you to execute. The advantage of this system is that your emotions do not play a role in trading; trades are decided based on the rules you develop initially as part of the system. It is not difficult to determine the initial capital is such cases.
You must first decide how many positions you are likely to hold at any point in time. Your initial capital should be 1.5 times the margin requirement if you take only long positions. But if you take short positions too, the capital should be at least twice the margin requirements, as short positions are more risky. Alternatively, you can size your trading capital based on maximum drawdown (MDD). This refers to the maximum loss on derivatives positions during the period for which you back test your trading system. Specifically, your initial capital should be at least twice that of the MDD.
Note that your decision to trade options must not be based on your trading capital; it must be based on your view of the underlying. The more confident you are about the directional movement of the underlying, the more you should lean towards futures contract, given its near one-to-one movement with the underlying.
What if you do not have a nondiscretionary trading system? Your trading decisions are then based on your continual interpretation of price charts. You could still use the above rule-based on margin requirements. Alternatively, you can allocate not more than 30 per cent of your total investment capital towards trading; at least 70 per cent of your investment capital must be allocated towards your goal-based investments. Determining your initial capital is important because you could face a series of losses. Call this the risk of ruin. Your account must have sufficient capital for you to continually trade and recover these losses.
Optional reading
Traders typically use a combination of discretionary and nondiscretionary system. That is, the system generates rules, but the trader decides whether to place the trade. Even in such cases, capital rules that apply to nondiscretionary system can be applied. It is also important that you follow strict risk management rules (price and time stops). Once the trading system generates gain, it may be optimal to takeout a predetermined amount (say, 40 per cent of the realised gains) and place it in short-term interest-bearing investments. This can be ploughed back into trading when the timing is appropriate.
The author offers training programmes for individuals to manage their personal investments
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