This concept involves structuring, or carving, our account into capital segments so we can better manage our risk and gauge the effectiveness of our trading. While there is no one “right” way to accomplish this task, the mere understanding and implementation of this process is important.
There are several ways we can structure our trading account:
- Fixed Dollar Amount or Percentage Risk Amount: This is the most straightforward and simple way to structure an account. I recommend that new traders use this system or a system similar to it. Suppose we have $25,000 in our account. If we choose a fixed-dollar risk amount of $500 per trade, this means we have defined our initial risk, something many traders donâ€™t do. If we choose to take 1% risk per trade, weâ€™ll start with $250 ($25,000 x 1% = $250) of risk per trade and the 1% will fluctuate based on the account size as the account grows or shrinks. If we have a series of losing trades and the account has $20,000 in it, the initial risk is now $200 ($20,000 x 1%).
- Product: This involves allocating a percentage of your account toward a market sector or specific product. For example, we may only like to trade E-mini S&P, gold, and corn futures. As such, if we have $30,000 in our account, $10,000 will be put toward each product. If we find ourselves trading well in a particular market or taking drawdowns in another, we can re-allocate capital more efficiently. Perhaps we do not understand the grain complex well so we decide to stop trading corn as we seem have better results trading the S&P. By tracking our results in each market, we can distinguish between what is working and what is not.
- Ideas: This involves taking a percentage of our account and placing it toward a specific idea or ideas. For example, after watching corn trade lower for weeks on end, we allocate 10% of our account toward buying various options betting that the price of corn will rise. We spread these bets over several types of options and may even use various call strike prices or several different debit call spreads. Another example may be to allocate 5% of our account toward assuming that the price of the euro currency will fall. This may involve building into a futures position and risking 5% of the account. If the idea goes bust, then the idea goes bust, but this gives us a way to control our upfront risk.
- Trading Style: This involves allocating capital toward certain kinds of trading. For instance, we may want to employ 40% of our capital toward building long-term fundamental positions in the 10-year note and corn. Thirty percent of our capital is used to trade technical swing set-ups across any market that fits the criteria for trade entries, 20% is dedicated toward directional option plays by buying calls and puts in stock indices, and 10% is used for intra-day trading opportunities across all markets.
- Risk Management Strategy: This involves allocating capital toward ideas using various initial stop exit plans. For example, 50% of our capital may be dedicated toward using specified volatility stops, 20% may be used toward fixed-dollar stops, 20% used toward a fixed percentage of our account, and 10% using a time-based stop system. Do we find one type of strategy that works better than another kind? If so, why?
There is no golden way to structure our accounts. We may develop and innovate on these areas above or use a combination of all five. The core idea is that we do not view our account as one whole piece. We should be strategizing and incorporating slices of capital in different ways. If we are simply throwing ideas into the wind without a firm understanding of our mathematical framework, there is little chance we can survive in the long-run.
Furthermore, we will be able to get specific feedback based on how we trade. Do certain styles match our risk personality better than others? We can adjust the capital allocations to suit our strengths and cut down or eliminate allocations that are not working. These results give us the ability to innovate and assess our strengths and weaknesses.
We should always be challenging ourselves to push the boundaries of our thinking and how we can employ capital more efficiently. Structuring our account helps us in this challenge.
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