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Fortune favors the . . . . .


Last week, in the aftermath of PFG Best’s implosion, I talked about a certain type of risk that most American traders don’t spend a great deal of time thinking about.   Most people, myself pretty much included, believed that it’s our money is safe in our trading account.  After all, the money is kept in “segregated” accounts – separate from the ones the broker uses for operations.  It’s illegal for the broker to take this money.  The broker can even collect interest on that money.  (In California, at least, we can’t even collect interest on money we hold in Trust accounts for real estate.  So it sounds like futures brokers have a pretty cushy deal going on.)  In addition, what percentage of traders lose money?  Somewhere in the 90% area from what I can tell.  So, even if you have a slimy broker and for some reason that money isn’t actually used to process trades through that voodoo I explained in my last post, it isn’t like the broker has to give back money lost by individual traders through their lousy trades.

Wow, with all that going in their favor, maybe I should look at becoming a broker.  Anyone have $25 mil laying around that I can borrow?  (If I had that kind of money, I’d buy a little more real estate here and there by the way.  I think the regulatory environment in futures is way too unstable. – More on that at a different time though)

None of these assumptions immunize the trader and their account from the harsh realities of corruption.  Sure, money is kept in segregated accounts, but apparently it doesn’t need to actually be there.  The great thing about Corzine, and Russ, and Bernie is they concern themselves less with what they should do or what is legal and more with they can get away with and for how long.  (Before all my short sighted liberal friends come out of the woodwork and tell me how much more regulation the private sector needs, consider Fannie Mae, Freddie Mac, Barnie Frank and Franklin Raines probably didn’t do anything blatantly illegal when they jointly engineered the largest government run ponzy scheme in our nation’s history.  The government engineers disasters it doesn’t prevent them.  But more on the banking industry and government greed later on.)

To be successful traders need to play by certain rules.  Let’s talk about money management.  As traders, we hear time and time again that we must manage our risk and only risk a certain percentage of our account if we want to avoid a blowout.  I think I’ve written on this topic before, and I may again but only with certain caveats in place.

Assuming we should only risk 2% of our account on any given trade what sized account do we need to make a living? (Lets take compounding out of the equation for a minute, and assume we pay ourselves a salary at the end of the month from our trading account to our pocketbook.  Just for ease, lets also assume we only take one trade a day.  And lets assume that trade is a winner 80% of the time.  So that means we max out our risk to 2% a day, rather than 2% a trade.  And I rather like this philosophy better anyway).  To make it easy, I think most people would agree we could live fairly well by making $500 a day 80% of the trading days.  Lets pretend like we break even the other days.  Remember, this is make believe.  That isn’t enough to get rich, but around $100,000 a year is enough to be comfortable.   If we’re only risking 2% of our account on any given trade that means we need an account of $25,000.

We’re talking rather hypothetically here I realize.   I don’t know many traders who make a 56% return a month, but I’m trying to get us to look at return differently.  (That being said, I do know some traders who make this type of return on a consistent and regular basis, who suffer minimal drawdowns and have been in the game a long time.  So this is very possible. But again, I’ll write more about realistic return expectations at a later date.  I’ve mentioned before, some of my highest investment returns come from some of my least risky investments.)

Let’s take our hypothetical to the next level.  If we can make $500 a day with $25,000 why shouldn’t I simply not pay myself the full amount and build up to where I have a $50,000 account or a $100,000 account.  Then I can make $1,000 or maybe even $2,000 a day.  Well, now we’re on our way to getting rich.  But are we being smart?

Well, I don’t know about you guys, I’ve lost $25,000 before and it isn’t fun.  But it also isn’t that hard to recover from.  So, if my broker goes under I will still be ok.  I’ll just complain a lot.  How many in the room have lost $50,000 or $100,000?  Or if we’re playing the compounding game how does $200,000 or $500,000 sound?  (no comment at this time regarding how much you can lose if you invest in real estate at the wrong time – but it’s a lot).  Everyone has a magic number that they can afford to lose.  If your magic number is in the  $500k range, give me a call and let’s talk about how we can make a nice safe easy 10% a year  return for ya.  My magic number was always 1 – 2% of my account.  It was never 100% of my account.  What’s your magic number?

Lets look at it the other way.  If I have a $50k account, how much margin do I actually NEED to make $500?

Lets throw some assumptions in there.  One lot, 50 pips take profit with a 50 pip max loss would be…  Oh shoot, time for some math.  Alright, a pip of GBP/JPY is worth how much in US Dollars?  Do I exchange the JPY part or the GBP part into dollars?  How much is a Yen worth?  How much is a Pound worth???? An to heck with it, this is too confusing.  Sure I have a minor in math, but I’m horrible at arithmetic and besides, that stuff isn’t very useful.  Let’s just round up and say we only NEED $5,000 of our $50,000 account.

Well heck, what’s the other $45,000 doing?

Um, hanging out, that’s what it’s doing.  It’s sitting there, in an unsecured account waiting for your crooked broker to steel it and use it to fund their corporate jet.  Now how safe do you feel?  And here I thought I was trading intelligently, managing my risk, being careful playing by the rules.  Well, the only rule that matters is what you can do and what the other guy can do.  If the other guy can forge documents for 20 years, steal $200,000,000.00 and buy that aforementioned jet, maybe they will do so and maybe they won’t, but would you rather be safe or sorry with your extra $45,000?

So what do we do?

We stick it in a bank account where it’s FDIC insured and collect our < 1% / year interest.

Oh great, now you sound like my grandma.  As long as we’re at it, why don’t I just bury my cash in the back yard and buy gold in 1983 when it’s over $600 / oz.

Hear me out.  Instead of looking at your trading account itself as a multiple of your risk capital, look at your trading account as your risk capital.  I never thought this was necessary.  I’ve been a big proponent of saying one’s trading account isn’t one’s risk capital; one’s risk capital is the maximum exposure of the entire account at any given time.  That sounds reasonable right?  Well, only if you don’t consider all the risks.  There’s that nasty broker risk again.

What goes through one’s mind when they think of things this way?  Can I make $500 / a day on $5,000?  What happens if I blow up my account?  Is this a realistic expectation for my trading style?

The answer to this is: it depends.  Mathematically yes you can make $500 a day on an account that size.  But is this realistic?  Can I actually make $100,000 a year with only $5,000?  And, what about that other $45,000 you have laying around?  Go buy a 6 series?  Buy a house? Invest it in something else nice and safe (government bonds perhaps).  No, keep it there, in your savings account.  If you lose your trading account for some reason, wire more money over or pick a different broker if you fall victim to broker risk.  I don’t want to say you should consider your savings account as part of your trading account because that is risky.  Any veteran of this game knows it’s dangerous to live off their trading until they’ve already proven they can trade well enough to live off of.  Open a separate savings account that you use for trading.  Start a different “trading” savings account.  Hey, if the paperwork is too much effort, just remember how much you’re saving by not losing your entire account to corporate jets.

If you had a business would you risk $50k in an unsecured investment?   Does it make sound business sense to have that much money tied up and not safe when you really only use a fraction of it?  (now I suppose it depends on how much you have to risk and what type of business you’re in – but I sure wouldn’t do that in real estate very often.  The last time I spent that much money, I was renovating a large building and spent every day supervising the work making sure my investment was safe).  Why would we treat this business any different then?

All this is well and good, but what do you plan on doing to make sure your investments are secure?

About two months before PFG went under, I had a personal trading account with them.  I am very careful to manage my risk in a way in which I’m comfortable.  Generally, I never had 3% of my entire account in danger at any given time.  After all, my account was large enough where if I was only working on an expected 1:1 payout, that would be plenty.

Then, a few ideas struck me.  First is that I never used more than a fraction of my available margin at any given time.  I think I was really heavy once and had about 20% tied up.  That’s a lot in the forex game!  I decided it was a really dumb idea to have that much money sitting at one broker.  I also needed to fund a little renovation project and knew I wouldn’t be trading with any volume for a few months and there was no reason to expose my account to unnecessary broker risk.  In addition, for administrative purposes, I wanted to move this money from my personal trading account to a newly created company account.

So, on April 20, 2012  I made my luckiest trade of the year:

Of course I still have a trading account and still make trades, but my risk capital and risk profile are significantly different than they were just a few months ago.  Who would have thought, an argument for using more leverage can actually make sense as long as you still manage your risk.  Maybe I’m overly paranoid, but just because you’re paranoid, it doesn’t mean they aren’t out to get you.

How am I managing everything now?  Wait around for the next blog post and I’ll talk about it.

Happy Trading,


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