How to Choose the Right Capitalization for Your Trading

One of the things I have been really careful about, since the beginning of my trading career, is the right capitalization. In other words, I have always avoided being too under-capitalized. In my portfolio, I risk only a reasonable part of my capital.

In this regard, I have gone a long way of trying out many different rules and methods how to setup the optimal capitalization, and I can say that all you really need is to create and follow just a couple of simple rules.

For example – in the time when I started trading ATS, I set up a simple rule that works pretty well for me and that I really can recommend for others to start with (I repeat, it is just a rule for the beginning, by the time you will get more and more experience you should start thinking more complex about the capitalization). The basic rule is: Capitalize yourself by 4-5x of the maximum drawdown amount that you have from your historical backtests. For my own trading, I have capitalized 5x more, but I am rather conservative, I can also imagine working with only 4x of your historical drawdown.

Let’s take a realistic look for the right capitalization we need for each market.

I will start with rather extreme value. You can create a system for Russell 2000 (TF) market with the maximum historical drawdown on 1,500USD level. The right capitalization for such system would be between 6,000 and 7,000 USD. But I have to mention that this is rather low drawdown for a TF market and that most of my systems for TF market have the maximum drawdown 3-4x higher. In other words, it is quite a luck to find a system for TF market with such low drawdown and the right way for small accounts would be to look for ATS in “cheaper” markets.

One of those can be, for example, E-mini Dow ($5) Futures market (YM) where most of my systems have the drawdown around 2,000 USD. The right capitalization for these systems would then be between 8,000 and 10,000 USD. With similar capitalization you can also trade E-mini S&P MidCap 400 market (EMD), where you can create systems with a drawdown on the same level (about 2,000USD).

As you can see, you have something to choose from even when having rather small trading account.

Usually I use for my trading rather big stop-losses. They are just protective stop-losses and are hit really infrequently (0-2x per year). In the matter of fact, the real average loss is much lower, so you don’t need to be afraid of higher stop loss values.

When it comes to the whole portfolio, the situation is slightly different. For a portfolio, I have always followed this rule: I capitalize 4-5x of the maximum drawdown from Monte Carlo Analysis of the whole portfolio I intend to trade. Yet with more experience and the growing size of your account, the same applies to single strategies – you start to consider more complex variants. But in the first couple of years, this simple rule can work for you really well.

Let’s take a look at a specific example.

I do the Monte Carlo Analysis in an MSA program. It is quite simple to use, all you need is to click on a button to get the results. As an example we can use a simple, low-correlated portfolio composed of 3 systems. The whole portfolio has the historical drawdown of let’s say 4, USD, after Monte Carlo Analysis 5,800USD. The appropriate capitalization then would be 5,800 x 4 = approx. 23,200 USD (in my conservative case slightly higher). The important point is that even with a small account you can, under certain circumstances, think about small portfolios. It is not as easy as with bigger trading account, but, theoretically, you can build a portfolio with about 15,000 USD account and keep this basic rule of portfolio capitalization at the same time.

It is important to note that I myself would never let any system to reach 4-5x of the maximum historical drawdown. After passing the 1,5-2x of the maximum drawdown I would the system turn off (or reoptimize). This is yet another rule that can save us from losing the whole account when the things go the wrong direction.

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