The advantage to trading vis-a-vis investing is a flexibility of attitude. A trader is prepared to take the short side and to look at a wider array of markets and instruments. The downside to a trading attitude is acceptance of higher risk.
One way to win or lose a fortune quickly is to dabble in highly-leveraged instruments. Stock and index futures leverage of 10:1 is on the lower side of the available leverage ratios. Forex futures contracts come at 50:1. Many commodities offer high double-digit leverage.
Index option premiums are at about two per cent of the underlying value.
At 10:1 leverage, the return on a one per cent swing in the underlying is plus/minus ten per cent. At an option premium of two per cent of underlying, the return on a one per cent swing may be 50 per cent. Stocks and indices move 1 per cent or more most days.
A derivatives trader could see his entire capital wiped out or doubled, inside 10 sessions of average volatility. Index derivatives and stock futures generate huge volumes so this is obviously a risk most traders willingly take.
Managing capital is vital, given high leverage. No matter how good you are at predicting market direction, you will be wrong every so often. If you don't know how to manage your money, those losses will wipe you out.
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Successful traders have successful stake management systems in common. The Turtle Trading system ensured for example, that in the worst case scenarios, the trader would exit for a maximum loss of about 24 per cent of capital.
The Turtles never committed more than two per cent of capital to a given trade and never held more than 12 open positions. They used a complex system of stop losses and looked for inverse correlations between holdings to reduce the chances of every position losing at the same time.
There's a large toolbox of stake management methods available. Stake management starts with a few basic assumptions. The trader factors in the chances of a loss before entering, and the trader admits that any given position could trigger a loss.
Almost all successful traders use systems where they commit equal amounts initially to every trade. It doesn't matter how confident they may feel. Some systems - quite a few, in fact -- involve pyramiding. Once a trade goes into profit, it's okay to add to the position.
The logic is simple. Say your system, identifies ten potential trades. If the system is very good, maybe seven of these will be profitable. But you don't know which seven. If you commit large sums to the three losing trades and small sums to the seven winning trades, you see net losses. Once a trade starts showing profits, there is reason for greater confidence and the position can be increased.
Most successful trading systems recommend that not more than 2-3 per cent of total capital should be committed to leveraged trades. Again the logic is easy to understand.
At a two per cent commitment, you are guaranteed a minimum of 50 trades. That gives you some time to recoup if you start with a string of losses. Many conservative systems recommend one per cent initial commitment, ensuring 100 trades at minimum.
All successful traders set some sort of loss limit on every trade. Some systems use mechanical stop losses, others use mental cut-offs. But a disciplined acceptance of loss when it occurs, is vital. If the loss limit is hit, the trader must exit the position without making exceptions.
These aren't difficult rules to understand. The barriers to following them are mainly psychological. It's tough for anybody to admit that they're wrong and cut their losses. Anecdotally, ten per cent of traders make 90 per cent of the profits, which is indicative of how difficult it is to be disciplined.
One implication of trading small positions relative to total capital is that the trader shouldn't be under-capitalised. Minimum position size is dictated by the exchange. Say you need Rs 50,000 margin for a single trade.
You should commit between Rs 15 lakh (minimum) to Rs 25 lakh as your total capital before you embark on a trading career. Most traders are under-capitalised or, another way of looking at it, they take positions that are too large for their comfort.
Any trader who freezes operation, until they have implemented a stake management system, is likely to see enhanced future returns. Anecdotally, very few people seem to have the discipline and focus required to do this.