Every trader wants to trade a well-funded trading account—such as a $1,000,000 account—but very few of us get to do that. Most traders are stuck with trading relatively small accounts or those that are just covering the required margin.
Trading a small account requires strict risk control and money management, because there is no buffer against mistakes or any unexpected losses. For example, if a trading account only covers its required margin by $500, and it takes a $600 loss, the account will become untradeable until additional money is deposited.
Here are some tips for those trading a small account.
The Limitations of a Small Account
Trading a small account is much more difficult than trading a large account. Large accounts are buffered against mistakes, unexpected losing streaks, and sometimes even bad traders, but small accounts have no such buffer.
Even beyond the ability to afford losing streaks, trading a small account has psychological issues that make it harder to trade well. For example, when a trader knows that they can only afford a single losing trade before their account becomes untradeable (because it will no longer cover its required margin), the pressure to make a profitable trade is enormous.
If the trader handles the pressure of small account trading well, this might not be a problem. However, even the best traders have losing trades, so a trader must prepare for that psychological stress.
There are also differences in what a trader with a small account is legally allowed to do. Large accounts can be used to trade any available market, but small accounts may only be able to trade certain markets in certain ways.
Large accounts allow more flexible trading—like multiple contracts and short positions—whereas small accounts may be limited to long positions that can be covered with cash. Decisions like what positions you can take and how much leverage you can use are established by brokerages, but there are legal limits, such as a 2:1 limit for how much you can borrow to buy stocks. To legally be allowed to borrow money to trade, you must have at least $2,000, and to day trade regularly as a pattern trader in the U.S., you'll need at least $25,000.
Advice for Small Accounts
With all of the disadvantages, it appears as though it is not possible to trade a small account profitably. However, this is not the case, and small accounts are traded profitably by many traders—including professional traders. The following advice is provided from the perspective of undercapitalized accounts, but the advice applies to all trading accounts, even the $1,000,000 accounts.
Trade Using Leverage
Trading with leverage allows small account traders to trade markets that they cannot trade using cash. For example, when you're day trading individual stocks, you can typically trade up with up to four times the amount of cash you have in your account. However, trading the same underlying stock using the options or warrants markets (both highly leveraged markets) only requires approximately 15% of the trade's value in cash.
Leverage and margin requirements should be understood before trading. In this example, investors should not necessarily use leverage to increase the trade's size—the number of shares—but rather only to reduce the trade's margin requirements.
Traders with well-funded accounts have the luxury of making trades with high risks—like those with large stop losses relative to their targets. A trader with a small account must be more cautious and make sure that their risk-to-reward ratio and their win-to-loss ratio are being calculated and used correctly.
Adhere to the 1% Risk Rule
Trading following the 1% risk rule provides a small account with the same buffer (against mistakes and unexpected losses) as a large account. Many professional traders abide by the 1% risk rule regardless of the size of their trading accounts, because it is a very effective risk management technique.
The Bottom Line
Some traders adamantly state that undercapitalized trading accounts cannot be traded successfully. This statement is not true. Small trading accounts may be more difficult to trade successfully, but if they are traded correctly, there is no reason why small trading accounts cannot be profitable.
Small account traders can make a good living from their trading, but they must control the stress that is often associated with undercapitalization, focus on risk management, and correctly apply their risk management techniques—especially the 1% risk rule. With those factors in mind, they may be able to turn their relatively small account into a larger account.
Frequently Asked Questions (FAQs)
How do you grow a small account?
Profitable trading is one way to grow a small account, but if you're being conservative and adhering to the 1% risk rule, then the growth may occur more slowly than you would like. You could take higher-risk/higher-reward trades, but then you would expose yourself to the possibility of completely wiping out your account. Many traders with a small account will find that they need external sources of income in addition to trading—such as a day job—to build meaningful capital.
How do you trade a small account without violating the pattern day trading rule?
If you have less than $25,000 in your brokerage account, then you are limited to no more than three day trades per week. A "day trade" is defined as opening and closing a position on the same day, but the specific trade orders used will depend on the type of trade you're making. For example, a short position is opened by selling and closed by buying. As long as you limit yourself to three day trades per week, you won't violate the pattern day trading rule.