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Trading With Limited Funds

Posted by Paul Grierson  |  February 15,2013  |  13:18 PM

Investing - Trading Floor

Introduction
The goal of this article is to offer some tips and things to consider to those of you who want actively trade stocks or other financial instruments, but don’t have a lot of cash to trade with.

For purposes of this article, we use the terms “trading” and “trade” to mean an active style of investing in contrast to a buy and hold approach. Further, this article is meant for retail investors and is limited to the types of trading normally available to small, retail investors. The discussion focuses on stocks, but many of the concepts can be used when trading other financial instruments.

THIS ARTICLE DOES NOT make any attempt to give advice on determining when to buy or sell or what to buy or sell, developing a plan, choosing an investing style or financial instrument, or any of a myriad of things you should know and think about before you begin trading. The internet, media and libraries are full of advice on buy and hold investing as well as trading in general. You should know the basics and preferably have investing experience before you begin trading.

Without discipline and a good plan, your trading career is likely to be short.

Trading With Limited Funds
However, in spite of all the advice out there about investing and trading, there is not much guidance about how to trade when you aren’t in a position to commit fairly large amounts of capital. This is probably because the basic advice is don’t do it – and probably for good reason.

But we all know that there are a sizable number of you who are going to do it anyway. This article is for you.

Taking a more active trading role for at least part of your portfolio does offer an opportunity to get better financial returns, and much more quickly, than with traditional buy and hold investing. Plus there are the psychic returns. Apart from any financial returns or losses, many simply enjoy the trading activity. Some even like to trade in volatile stocks that resemble gambling more than investing.

Hopefully this article will give you some ideas that will help keep you in the game and improve your financial returns.

But don’t kid yourself – when trading with a small amount of capital: discipline, adherence to your plan and close attention to your positions is more important than in almost any other form of investing normally practiced by retail investors. Without a plan and discipline, you will likely be out of business in short order.

Trading – Why?
Many investors like to devote a portion, or even all, of their portfolio to active trading. Instead of trying to profit from long-term uptrends, traders can often enjoy increased profits from short-term price moves – both up and down.

In addition to potential financial returns, investors who enjoy the act of trading, or even essentially gambling in highly speculative stocks or other assets, get a psychic reward that adds to financial returns or offsets part of any losses relative to buy and hold investing.

Trading – Some Variations
For some, trading means “day trading” – or getting into and out of a stock the same day. This requires constant vigilance and is subject to special margin and regulatory requirements. Day trading is probably not an option if you have limited capital, and thus is not covered explicitly in this article.

Others enjoy trading highly volatile penny stocks, some of which may be involved in an aggressive investor awareness promotional campaign. The holding period for these stocks is usually a few days or weeks at most, and the trader should be prepared to check the stock’s activity at least two to three times a day, and preferably more often. And if one of these stocks is experiencing a big run-up in price, it should be monitored more or less constantly so a profitable exit can be executed on the upswing rather after the stock begins its almost certain crash.

And finally, some investors like to trade in more traditional stocks which they expect will experience significant price fluctuations over the relatively near future. Reasons for the expected price swings include a stock’s history of price volatility, upcoming big news such as the results of a clinical drug trial which could affect a stock’s price, some publicity (either good or bad) that is buffeting a stock’s price, and/or any number of other internal or external reasons. While these positions should also be monitored closely, they normally do not require as much attention as day trades or highly speculative, promoted stocks.

A key here is that no matter what you think of a company’s fundamentals, the plan is to make money based on short-term price fluctuations. So these trades require much more attention than buy and hold investments.

Trading With Limited Funds – Some Basics
Since traders with small accounts run a much greater risk of having their accounts wiped out, remember to never risk money you will need to pay the mortgage/rent, take care of the kids, etc.

What is a small trading account? The literature often refers to somewhere in the $5,000 to $10,000 range as a starting point for beginning a trading program. But the reality is that many investors try their hand with $1,000 or even less. And many of those who are reading this article because they are eager to start trading will ignore the recommendation to wait until they have $5,000 or more to to play with.

Just remember that the smaller the amount you start with, the more careful you must be.

The first rule of trading for small investors is capital preservation. You must carefully and intelligently manage your money. There will undoubtedly be losses – the key is to live to trade another day. And for traders with small amounts to risk, this should mean starting out with a relatively conservative trading strategy, which can be liberalized as their trading account grows.

Traders with small amounts to risk face a difficult balancing act. When they try to spread their risk over investments in a number of different stocks, they incur high commission costs relative to amounts invested – which eats into any profits and magnifies losses. On the other hand, a large loss from over-investment in a single stock could cripple a trader’s ability to continuing trading without additional investment. We discuss a way investors can make this balance more favorable below.

Crucial Consideration – The Impact of Commissions
Traders with limited funds must carefully factor in the impact of commissions as they they consume a bigger percentage of profits on small trades than on large ones. This section is intended to help you visualize the impact.

For ease of calculation, let’s assume your commission cost is $10, which means $20 for a “round trip”, or both the buy and sell commissions. Further assume that you are active for 50 weeks out of a year. That means each round trip that you make per average week (this does not mean you are buying and selling a single stock within each week, only that you average 1 buy and 1 sell transaction per week) will cost you $1,000 in commissions per year (1 round trip @ $20 times 50 weeks). From there it’s easy to see that averaging 2 round trip trades per week is $2,000, 3 equals $3,000, and so on.

You can look at this from different angles:
1) Overall returns required to be profitable: Even if you can commit $10,000 to trading and trade once per week on average, you must earn 10 percent on your original capital just to break even. And if you average two trades per week you must earn 20 percent, and so on.

With starting capital of $1,000, you must make trading profits equaling 100 percent of your initial capital just to break even on one trade per average week, 200 percent on two trades per average week, and so on.

2) With limited funds the number of trades you can make is also limited as a practical matter: Say you start with $1,000 and want to trade 4 times in a month, investing $300 each time (obviously you would have to exit at least one position to make the 4th investment). Further assume that you have 2 winners and 2 losers – and your 2 losers break even before commissions. That means that on your 2 winners, your combined gain must exceed 13 percent in a month or less ($80 in commissions % $600 invested in the two winners) before you see an overall profit. And realistically your losers will actually lose money, not break even, so you must do much better than average 13 percent (and remember that this profit must be made in less than a month) on your winners.

The point of this discussion is not to discourage you, but to help you understand that to be successful at trading with small amounts of capital you must be realistic and disciplined – and that you will be limited in the number of trades you can make. Until you build up your stake, you must be very selective and not go overboard making a lot of trades or buying every seemingly hot stock that comes to your attention. Limiting your losses on losing trades (discussed later) is also important.

As you increase your capital, you can begin increasing your trading frequency and the amount invested each time.

Tips Regarding the Amount to Invest On Each Trade – Plus How To Increase This Amount By Reducing The Amount Actually At Risk
Ultimately this is a question everyone must answer for themselves. But the basic concept is that if you start with $1,000 in your account and lose $800 on your first trade, for all practical purposes you’re out of business unless you inject new cash. Going large is tempting because of the smaller percentage impact of commissions – and quite frankly it can be exciting to place a big bet – but you risk losing your ability to continue trading.

BUT – the cost of a stock is not necessarily the amount you have at risk. For example, a $500 investment from a $1,000 trading account looks like risking 50 percent of the account on one trade. But if you have a stop-loss at 5 percent below the $500, or $25, you are theoretically risking only 2.5 percent of your capital (ignoring the cost of commissions).

The use of the phrase “theoretically risking” is very important to remember. Many of the most exciting trading opportunities are in thinly traded (illiquid) stocks and stocks that are subject to extreme price swings. In these cases, your stock may be sold at well below the stop-loss point. So a stop-loss, while it should help reduce your loss in any case, does not provide a guarantee.

This is a little off the topic of the section, but you can also use trailing stop-loss orders which increase the automatic trigger price to sell as a stock’s price rises. On one hand, this can help lock in a profit on a fast-rising stock. But on the other hand, if the stock price bounces around on its way up, you could end up selling the stock well before it reaches its potential.

Also consider limit orders – which are orders to buy (or sell) at a specified price or better. These can be especially important when trading volatile stocks. If you place a simple market order to buy when a stock’s price is $20, your actual purchase price could be $25, $30 or even more. This could mean the difference between a profit or loss – plus it might also ruin your capital allocation plans. The problem with a limit order (looking at it from the buy side here) is that if you place a limit order above the market, you very well might end up paying your limit order price rather than a lower market price. If you place the limit order below the current market price, you may never buy the stock at all (or worse, not buy it on the way up, but instead when the price is crashing).

This section is not intended to be a proper discussion of various types of orders. But as a trader, it’s important that you educate yourself on this topic so you can use an order type that meets your expectations for a particular trade.

A common rule of thumb is to limit your exposure on any one trade to 2 percent of your capital. But with a small amount of capital and investments in volatile and/or illiquid stocks, it will probably be difficult to adhere to this rule and trade profitably after considering commission. Plus many of you are risk-takers by nature and will exceed recommended limits in any case. Just be careful out there and take steps to limit your downside as a means to preserve your capital.

Summary
Trading is an active style of taking part in the stock market. Besides giving you a chance to outperform buy and hold investing, you get to experience the fun and excitment of active participation if that suits you. And as noted near the beginning of this article, even if you’re not so successful or even loss a little bit, the sheer enjoyment of your trading activity may make it worthwhile.

Hopefully, this article has given you a few helpful ideas to consider as you develop your trading plan.

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