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How to Manage Risk in a Small Account

How to Manage Risk in a Small Account

 

The methods of managing risk in a small trading account are very different from that of a large account.

While traditional financial theory would posit that the same portfolio-optimized risk management principles would apply regardless of portfolio size, the real world is more cruel and less simple. 

This problem is compounded when you’re an aggressive day trader, aiming for maximum capital appreciation.

Defining Small Accounts vs. Large Accounts

Depending on your financial situation and trading style, your definition of a small or large trading account should differ from mine.

However, for the sake of this article and those employing an aggressive day trading style, we’ll consider all trading accounts below $10,000 to be small accounts.

Of course, those with less than $10,000 are most susceptible to the troubles of small account trading, but they still apply to some extent up to $10,000. 

The Goal of the Small Account Trader

If you consider the vast majority of investors in the equity markets, their goals are very different from the aggressive day trader. Most are saving for retirement and playing for compound interest. Or maybe they need somewhere to put their cash to beat out the purchasing power reduction of inflation.

But the day trader has a very different aim. For the most part, their returns are uncorrelated to the broad stock market because they’re trading micro price moves in hot stocks on both the long and short side. 

Day traders, especially those with small accounts, are looking to quickly multiply their account size through aggressive risk taking.

Most day traders with $10,000 accounts aren’t looking for a cozy 5% return on their money. The invested time simply doesn’t match the cash return. 

Small Accounts vs Large Accounts: The Reality

In practice, most small account traders don’t have a very large income or asset base to draw from. So if they blow up their account, they’re out of the trading game for a little while.

Large account traders tend to be wealthier and as such have a diversified portfolio of assets outside of their trading account. Blowing up an account for large traders might not change their life significantly, nor would it take them out of the trading game entirely. They can simply deposit more cash from elsewhere. 

For this reason and many others, small account traders are forced to manage risk in a more surgical fashion so they can ensure that they’re always staying in the game while still maximizing capital appreciation. 

But they’re stuck between a rock and a hard place. Their trading account makes up a large portion of their net worth so they’re forced to preserve it, but the reason they got into the game of trading is to multiply their net worth through an aggressive trading style. 

Large account traders simply don’t suffer from this tension, making their risk management much simpler and more to the book.

Risking a Percentage of Your Capital

The most basic risk management technique that all small traders should be using is to stop thinking in dollars and cents.

You should instead think in percentages: risking a fixed percentage of your account on each trade, rather than a fixed dollar amount. This way, as your account grows or shrinks, the amount that you’re risking scales with the size of your account. 

But it’s more than just thinking in percentages, it’s also about not risking too much.

Most trading literature suggests that risking 5% of your account on one trade is absolutely the most aggressive any trader should get, and that’s probably too high for the majority of traders in most situations. 

Your number is a personal choice, based on where you’re willing to compromise. There’s a tradeoff between risking more and growing your account more, and risking less but staying in the game and allowing your body of trades to benefit from the law of large numbers (if you have a profitable strategy). 

For small accounts, that compromise typically lies somewhere in the ballpark of 2%-5%.

Choosing The Right Strategy for Your Account

For most small account traders, high-risk, high-reward strategies like shorting parabolic penny stocks doesn’t fit their risk profile. That’s a situation where the stock can gap up 300% against you, not only blowing up your account, but potentially putting you in debt to your broker. 

While there’s a million unique trading strategies, most of them boil down to two basic concepts: momentum or mean reversion. When you trade momentum, you’re buying what’s going up. When you trade mean reversion, you buy what’s going down because you think it’s gone down too much.

Most mean reversion strategies don’t make sense for small accounts.

These are trades that make relatively consistent small profits, while opening you up to occasional huge losses. As such, they’re much better handled by traders with large accounts which can easily absorb some big losses without their strategy being interrupted. 

Mean reversion traders double down when they’re wrong, because they have the thought of “if it was a good deal at $15, then it’s an even better deal at $12.” Sometimes they’re wrong and buy on the way down until the stock consolidates around $5, leaving them with huge losses. 

The reason momentum trading is a great choice for small account traders is that it’s relatively easy to know when you’re wrong.

You’re following the trend. If the trend breaks, you were wrong and you can get out for a small loss. Generally, momentum traders only add to winning trades, if they add at all, so you’re not going to experience losses with a huge position.

Trade What You’re Willing To Lose

All of the money in your trading account should be expendable. If you’re going to need it for rent or groceries, then take all of that out and only leave what you can lose 10 minutes from now and be no worse for it. 

You cannot have one foot in the door and one out. You can’t simultaneously want to take aggressive risks with capital you’re going to potentially need. Your brain will sabotage you and you won’t be able to consider risks rationally.

Bottom Line

Many of the famous trading books will say that you can’t trade unless you reach an arbitrary dollar amount in your trading account.

Realize that most of these books are 10+ books old, before the days of free commissions and discount brokers mostly eliminating minimum deposits and many other fees. 

You can absolutely trade with a small account, but you should be realistic about the additional risks that it carries.