This is a great question, because it’s already showing that you have reasonable expectations when it comes to trading. The mere fact that you’re wondering this shows that you are smart enough to know that you won’t be turning $500 into $500,000 any time soon.
The way that we’re going to tackle this question is that we’re first going to talk about risk and reward, then we’ll get into the specifics of each asset class. Fair enough? Great.
Risk and Reward
Risk and reward… we all know what it is. We all know that there’s no such thing as a free lunch, and that with every reward comes a risk along with it, and vice versa; every risk comes along with it a reward.
Risk of Ruin and Expectancy
Risk of Ruin is the probability of blowing up your account, if you’re taking too much risk relative to your overall win-rate. For instance, if you have a low win-rate and are risking too much capital on your trades (relative to your total risk capital), the odds that you blow up your account (read: lose all of your hard-earned money) is very high.
Conversely, if you have a higher win-rate, you may be able to afford a few big losing trades because overall you win more than you lose. What’s important is to realize what you like best. Do you like to have more winning trades, but earn less on those winning trades? Or do you like to have a lower win-rate, but you make more on those winners?
The concept of always risking 1 to make 3 is not a hard and fast rule. If your overall expectancy is on par, you can have a win-rate of 80% by taking small winners (the closer your profit targets, the higher your win-rate) and afford to take some larger losses. *Disclaimer: this is not investment advice; whatever you do is on you.
Expectancy = (Win % x Average $ Win) – (Loss % x Average $ Loss)
A Sterile Example of Expectancy
Here’s an example of how you can profit overall with smaller profit targets in the E-Mini S&P 500 Futures (/ES):
The average 1 standard deviation move in the /ES is about 20 points. We can reasonably expect to make 2 points on a trade with an 90% win-rate (1 – (2 points / 20 1SD = 0.1) = 0.9). So if we’re trading 1 contract, we would make $100 per winning trade. Over the course of 9 trades we would make $900. If our stop is triggered only 10% of the time, we could theoretically risk 18 points ($900) on each trade and we would break even after 10 trades (less commissions). Here’s what it would look like in the expectancy formula:
Expectancy = (90% x $100 Win) – (10% x $900 Loss) = $0
In the same scenario, if you had a stop of only 9 points (instead of 18 points) here’s what the equation would look like:
Expectancy = (90% x $100 Win) – (10% x $450 Loss) = $450
Win-Rate And Mental Fatigue
Keep in mind, this is an example in isolation. What you do is your decision, but the point here is that you do not need to strictly follow a 1:3 (or 1:2, 1:5, 1:10, etc) Risk:Reward ratio if your overall win-rate is high.
Personally, I enjoy a higher win-rate because it is a lot less mentally stressful. The little wins mean more to me psychologically, than the giant winners that happen 5% of the time. The mental cost of having a low win-rate might also be something you want to consider.
It’s much easier to stick to your trading plan and keep a winning attitude, if you’re winning more often than you’re losing– even if you’re winning less on average (but earning the same, if not more, overall). I’m not trying to influence you one way or the other, let me be clear; it’s your choice.
Your Capital Is Your Breadmaker
If you run out of capital, you can’t make money with your money anymore– because you don’t have any more money. Whatever you do in your trading, your first and foremost goal is to protect your downside. If you do not adequately protect your downside, you run the risk of getting kicked out of the game.
I’ll say it one more time for good measure. This game requires you to have money to make money. If you lose all of your capital by taking a few dumb trades (where you risk too much), you can’t play the game anymore. There’s no referee, coach, or official that you can complain to in order to get back in. You’re out, until you build up your capital again by (dun-dun-dun) working a normal job.
Don’t screw yourself over by taking too much risk at one time.
Now That That’s Settled… How Much?
Okay, now that we’ve covered the risks and importance of protecting your capital, how much can you make? It depends on the asset that you’re trading, how much (reasonable) leverage you’re using, and how often you make trades. We’ll go over Stocks, Futures, and Options.
Futures can be traded on margin for as little as $500 per contract during market hours (you can’t hold the trade overnight without putting up more margin.
Because of the massive amounts of leverage available in the Futures market, Futures are going to provide you with the highest rate of return. However, just because you can use a ton of leverage doesn’t mean you should. For instance, if the E-Mini S&P Futures are trading at 2650 they have a notional value of $132,500 (2650 x $50 = $132,500).
The Futures Exchanges (such as the Chicago Mercantile Exchange) sets the margin for most Index Futures at around $5,000 per contract. That means if you trade 1 /ES Contract for every $5,000 in margin you have, you’ll be leveraging yourself about 26.5 times. In other words, if the /ES moves 0.25%, your account would move 6.6% (26.5 in leverage multiplied by the 0.25% move in the /ES).
This is great if you don’t have any losing trades. But everyone has losing trades, and that’s a lot of risk. That’s a 6.6% move in your account if the /ES moves 0.25%. If the /ES moves 1%, your account would move 26.5%. That’s no way to trade. That’s gambling at that point.
So how much capital should you have? It depends on what the notional size of the contract your trading is, and the level of leverage you’re comfortable with (if any).
For this article, we’ll assume you’re using premium selling strategies, rather than using Options for Stock replacement. Some say that selling premium is like picking up pennies in front of a steamroller. The reality is that selling premium is a good way to make consistent money, if you’re doing it in a smart way.
However, Options Spreads are a great way to boost returns and limit risk. With Options Spreads, your risk is limited to the width of the strikes of the spread. The lowest amount you can risk is $50 (if the strikes are $0.50 wide).
If you’re confused about the terminology of “strike width”, it might be a good idea to check out this nearly all-inclusive resource.
While it’s possible to make money consistently (i.e. have a win-rate of above 70%), selling Options will not have the same rate of return as trading outright Futures. But it’s very possible to make annual returns of between 20-30% by selling Options.
In order to trade Options, you will need a margin account. For more information on the capital requirements for trading Options, you can check out this article entitled “How Much Capital Is Required To Trade Options“.
By far, Stocks require the most amount of capital to make any decent money, but it really depends on the price of the Stock and the volatility around it. Most people trade Stock in 100 share increments, so every $0.01 change in the Stock reflects a $1 change in your PnL.
While that’s commonly the minimum trades size, you can trade however much Stock you want. The issue here is for accounts that do not have $25,000 in capital. If you’re under that amount, you will be subject to the Pattern Day Trader Rule.
The Pattern Day Trader Rule is a FINRA regulation that stipulates you cannot make more than 4 day trades within a 5 business day period. So for all you people out there thinking you’re going to make it big as a penny stock day trader on a $2,000 account, *cough* think again.
So if you’re looking make a living trading Stock, you’re likely going to have to be making multiple trades within a 5 business day period. You could always swing trade Stocks, in which case you would hold the Stock for multiple days/weeks.
Also if you’re trading with a smaller account, you’ll most likely be looking to use leverage to boost your returns. If you’re trading in a margin account, you can use 2x leverage if you hold a position overnight. This is good for those who have limited capital, but don’t want to overleverage themselves.
Food For Thought
So there you have it. Notice we didn’t get into Spot Forex in this article. That’s because the Spot Forex market doesn’t offer a lot of transparency to the retail trader, so we tend not to cover it too much.
Also, if you’re considering trading large Stocks like Apple, Amazon, Facebook, etc., you might want to consider trading the correlated Index Futures. If you have limited capital, you can get around the Pattern Day Trader Rule by trading Futures. If you do decide to go that route, I would caution you against using too much leverage (if any).
Anyhow, I hope this article was helpful to you in more ways than just 1. If it was helpful, please let us know in the comments below. Thanks for reading.