Arriving at a Suggested Dollar Value Per Contract
One simple approach to arriving at a suggested amount of capital to have in your trading account in order to trade one contract of a given market using a particular systematic approach is to add up the three values just discussed and divide the sum by 3. The formula is as follows:
(Optimal f in $ + Largest Overnight Gap in $ + (Maximum Drawdown in $ + Margin Requirement)) / 3
For example, let's say that you are looking to trade the Japanese Yen with a system you have developed. The optimal fvalue is $3,457, the largest overnight gap for the Yen to date has been $5,938, the maximum drawdown in testing using your system was $4,124 and the margin requirement for one Japanese Yen contract is $3,000. You can then plug these values into the formula to arrive at a suggested amount of capital:
($3,457 + $5,938 + ($4,124+$3,000)) / 3 = $5,506
For this example, it is suggested that you have at least $5,506 in your trading account in order to trade one Japanese Yen contract using this system.
This method takes into consideration three valuable pieces of information regarding your specific trading method in trading a particular market. Optimal/uses a scientific mathematical process to arrive at the amount of trading capital that should theoretically maximize your profitability if future results are similar to past results. Including the largest overnight gap for the market in question and the maximum drawdown using your approach to trade this market forces you to take into account previous worst-case scenarios.
If you cannot calculate an optimal f value you may wish to substitute an old standby rule of thumb value which is arrived at by multiplying the initial margin requirement for that contract times three. One reason for using optimal f is because the value it arrives at takes into account the actual performance of the system you are using. If your system is very good, optimal f will indicate that you can trade it with less capital than if your system is not as good. Using margin times three results in the same suggested amount of capital regardless of the performance of the system used.
Using margin requirement times three is an acceptable rule of thumb. However, in order to appreciate its limitation consider two traders who are both presently long T-Bond futures traders. Trader A uses an excellent systematic approach that consistently generates profitable annual returns while Trader В pretty much makes it up as he goes along. Is the risk the same for both traders? Herein lies something of a paradox. For any given trade the answer is "yes." Howeve'r, in the long run the answer is almost certainly "no." By virtue of using a superior approach to trading, Trader A has a greater likelihood of success and should be able to commit less capital than Trader B.
If you do not have any way to back test your system then the suggested formula for calculating a reasonable amount of capital to trade one contract of a given market is:
((Initial margin * 3) + Largest Overnight Gap in $) / 2
For the Japanese Yen the initial margin requirement (at the time this is written) is $3,000 and the largest overnight gap has been $5,938. According to this formula the suggested capital requirement would be:
(($3,000 * 3) + $5,938) / 2 or $7,469
These formulas are intended to help you determine the absolute minimum amount of capital you should have in your trading account in order to trade your desired portfolio.
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