The Importance of Trading Capital

In February, Michael Goode made an excellent video blog post on the learning curve for trading.  MarketMonk responded with an equally excellent comment, eluding to how many people quit trading because they finally realize how difficult it is to trade with a sub-$25K account.

I want to expand on the importance of trading capital, and how a lack of capital can be a big hindrance to your progress.  There are many ways that a lack of capital can make things more difficult:

1.  The Pattern Day Trader Rule.  If you have an account of less than $25K, then you are limited to 3 day trades per week.  This can impede your progress in many ways.  First, it doesn't leave you much room for error.  I've had many times where I entered a trade that I shouldn't have entered.  As soon as I realized I shouldn't have entered, I had to use up a day trade to get out of the trade.  You can use up your 3 day trades per week pretty fast that way.  Second, you might miss other good trading opportunities because you can't risk getting into a trade in the middle of the day and being forced to hold overnight when out of day trades.  Interactive Brokers won't even let you enter a trade if you're out of day trades; sometimes I like to make trades right before the market close, but IB won't let me do that and thus I've missed opportunities that way.

Now, this doesn't mean you can't make progress under the PDT.  It just makes it much more difficult, and makes progress much slower.  Tim Sykes took $12K and turned it into over $25K in 2008-2009; however, he wasn't strictly under the PDT because he was using Thinkorswim, and Thinkorswim was very lax at the time about the PDT.  In fact, I remember making 2-3 day trades each day with TOS in 2008 and never got in trouble for it (I have no idea how TOS got away with that).  So while Tim still would've eventually turned the $12K into $25K, it would've taken him much longer with another broker (or if TOS had actually been enforcing the rule like they do now).

2.  Day Trade Buying Power.  Many people think of the pattern day trader rule when it comes to a sub-$25K account, but there's more that limits you than just that.  You also have to deal with the limitations in buying power.  It's very easy to generate a day trade margin call if you liquidate an overnight position, and then use those funds to make a day trade with.  This has happened to me more than once.  This happens even if you have 3 day trades available to you.  To guard against this, you have to look at your buying power when holding an overnight position.  For example, yesterday I held ROHI long overnight in my TOS account.  My overnight stock buying power was reduced to around $700 when holding that position.  That means that, even though I sold ROHI today and did not make a day trade, I couldn't buy more than $700 worth of stock today.  That amount is not worth making any trades with.  I couldn't risk entering a position in the middle of the day, knowing that I may have to exit in the same day (and thus risk incurring a margin call).  So I was stuck to only being able to enter positions near the close, that I knew I would hold overnight.  This was despite the fact that I had 3 day trades available in my TOS account.  This can be frustrating when you see opportunities that you can't take advantage of.

This can be more of a problem if you have multiple small accounts, like I do (I have 4 accounts currently).  Except for my Cy Group account, I have to constantly monitor my other accounts so that I don't incur a margin call, as my position sizes in each account are very close to my max buying power.  The nice thing about multiple accounts is I at least get that many more day trades (and a better chance of finding borrows as borrow availability can vary from one broker to the next).

Now, you might ask why I don't just use my Cy Group account for most of my trading.  First, I can't trade OTCBB or pink sheets with that account.  Second, I can't access it from work as I'm behind a firewall (I only trade with my Cy account in the morning before I go to work)....I can only use brokers that have web interfaces.

3.  Limitations in Short Position Sizes.  Many brokers won't let you short stocks under $3.  Of the ones that do, like IB, you need to have $2.50 cash in your account for every share that you short.  So if I have $4000 in my account, I can only short 1600 shares of a $1 stock, even though it's only a $1600 position.  This is particularly limiting if you want to short a sub-$1 stock (like a 50 cent one)....you can't take a position size big enough to make it worth it.  So you may miss some of the sub-$1 pump and dumps (which there are a lot of).

4.  Limitation in Positions and Position Sizes.  This is a no-brainer.  The more capital you have, the more and larger positions you can take.  This increases the amount of money you can make.  The most successful traders I see, like Michael Goode, have accounts of $100 - $200K or more.  It can be tough to match Michael's success when you don't have the capital that he does.

5.  Can't Do It For a Living.  Even though you can be profitable with a sub-$25K account, don't expect to be paying the bills with the profits.  If you try to withdraw your profits, you won't be left with enough to trade with. 

This is all not to say that you can't be successful with a smaller account.  You can, but you definitely have an uphill battle and many obstacles to overcome (which is why I am continuously adding a bit of money to my accounts each week so that I will no longer have these obstacles).