FAQ: I Have A Small Account, Where/How Should I Trade It?

I get this sort of question a lot from people looking for advice on how to get started with a smaller account. Now it would probably be in my best interest to do what everyone else on Wall Street seems to do and feed you some investing strategy while encouraging you to come back to my blog for future tips and tricks. That being said, I created this blog to help people and the best way to do that is this:

Don't trade with less than $10,000!

While it's certainly possible to make money with smaller accounts, I have to strongly discourage it because the odds are simply stacked against you and trading is all about odds. 

I'll explain further.

For small accounts, the fees charged by brokerages represent a larger percentage of your worth than they would for a big account. That translates into requiring a larger percentage gain from your stock trades in order to stay profitable. Here's an example: Small account holder Average Joe buys 800 shares of XYZ at $2.50 a share. Millionaire Max buys 7000 shares at the same price. Within a short time, the price rises to $2.60 for a 4% gain on your investment. Not bad! That's a profit of $80 for Joe and $700 for Max. Unfortunately for Joe his broker charges $7.50 per trade, and $30 dollars a month for software and data feeds. which represents 56.25% of his profit! Those same fees represent only 6.43% of Max's gain.

To compensate for this problem, most novice traders will hold their positions longer, hoping for big percentage gains. Unfortunately, trading isn't that easy and most likely holding longer won't get you any more gains. In fact, you may end up in the red on that trade since more time in the trade equals more risk. In that scenario, all the fees stay constant AND you're going to lose money on that trade. This means that your next trade would need to net you even more money to make you profitable. Thus, your chances of success become less and less likely. You should be starting to understand now that all the little problems traders face are magnified by small accounts. And chances are, since you're new, you're going to be making more mistakes than quality trades.

Small accounts are also at greater risk of going bust than large accounts. You should never invest your entire account into a single trade because you can never be sure if you're right. If trading were that easy, everyone would be making money but the sad fact is that most people lose money because most people don't read this blog. Good traders only risk around 10% of their account on any one trade. If you have less than ten-thousand dollars though, that leaves you with a very small amount to trade and compounds the issue illustrated above. If you go all-in on every trade, you're probably just going to bleed your account into oblivion.

"But hey! I'm making millions on my paper trading account!"

Practicing on paper trading accounts does little more than acquaint you with a particular broker's software. Many of the variables that make trading challenging are diminished or removed in the paper trading world which can mislead you into thinking you're a bit more skilled than you actually are. One big reason is that paper trading is mentally distinct from actual trading because it doesn't punish mistakes in a meaningful way. Introducing the risk of losing your real-life hard-earned money is likely to influence the way you trade. Most notably your ability to accept a loss and get out of a bad trade rather than holding and hoping.

Furthermore, and much less obviously, paper trading diminishes the influence of liquidity and your role in that liquidity (if you want some clarification on liquidity and other basic terms, click here). In the real world, your trade order can influence the price of the stock. While this wouldn't be noticeable if you were trading GOOG, small accounts are probably going to be trading small cheap stocks which are much less liquid. These stocks are going to behave in ways that may not have been apparent in the paper world.

Shorting in particular is not well represented by paper trading. The biggest factor for this trading strategy is the availability of shares. The only way you're going to get an accurate sense of this issue is by actually trading. You have to short early (which is much higher risk) in the real world before the shares become unavailable to borrow. Once the odds are obviously in your favor and the risk is lower, the stock is probably not going to be available to borrow because everyone wants them at that point! As such, these borrows are often only available to large account holders who can manage these higher risk trades. Large losses don't put them out of the game. Shorting also involves borrow fees and fees, as I explained earlier, are bad for the small account holder.