How much to invest in a trading system? This is a question that many traders ask. While the calculations are very simple, traders can be unsure about where to start.
First of all, a trader must find out what he or she will spend on the use of a chosen trading system. The formula is very simple:
(Minimum Invested amount) * (System Performance) " (Trading Expenses) = or > 0
The profit that you receive from the system must at least cover the expenses associated with its use. This is the main criterion in defining the minimum recommended amount to try any trading system.
(Minimum Invested amount) = (Trading Expenses) / (System Performance)
There are usually two types of expenses. They are the brokerage commissions (every trader pays them) and the subscription fee for use of the trading system. If a trader does not subscribe to any online trading system, but has developed his own, he or she still may have incur expenses to personally test the developed trading system. These expenses may include a data feed fee, a chart access fee, a news feed fee, a fee for stock market reports and any other fee for information and or data with which to support the trading system.
To estimate how much you will pay in brokerage commissions, you need to know how often the trading system that interests you generates trades and how much your broker will charge you for buying and selling. The average number of trades per month can be obtained from the history of the trading system that you are thinking of using.
The system performance can also be obtained from the trading system's history. Of course, past results do not guarantee future performance, but an analysis of the history may give you at least a typical picture of what to expect from the system.
System Description:
An online stock trading system generates five signals a month and the system's average monthly performance based on past results is + 4%. Your broker charges you $10 for each transaction and the monthly subscription fee for using this stock trading system is $30.
Calculations:
Five signals per month is equivalent to 10 transactions (five to open a position and five to close a position) and mean that you can expect to pay $100 in brokerage commissions each month. Taking into account the system's $30 monthly subscription fee, your total expected monthly expenses with this system will be $130.
Using this number:
The Minimum Amount to Invest = 130 / 0.04 = $3,250
Now you can say that $3,500 is the estimated minimum amount to invest in the stock trading system described above.
System Description:
An online option trading system generates three signals a month and you conclude that you can expect a 10% return monthly from the invested funds. You pay $10 in brokerage commission for each transaction (options trade) and $60 monthly as a subscription fee for the system.
Calculation:
With an average of three signals a month, you will pay $60 in brokerage commission fees each month. By adding the system's $60 monthly subscription fee, you can expect to spend $120 per month on this trading system.
Using this number:
The Minimum Amount to Invest = $ 120 / 0.10 = $1,200
Keep in mind that the use of the compound effect is not recommended in options trading. Therefore, you can say that $1,200 is the estimated minimum amount to invest in each trade of this option trading system or 10% of a $12,000 options portfolio in each trade.
As a rule, the minimum amount required to use any trading system is the amount that may at least cover the expenses connected with trading, which include a brokerage commissions and a subscription fee.
Usually, we recommend calculating the minimum amount required to try the system before using it. The minimum amount calculation could be based on the historical performance of the options trading system. From the history, you need to find two numbers: 1) average number of trades per month, and 2) average monthly system's return.
For instance: In order to buy and sell options, you have to make two transactions and pay $30 commissions (or less, depending on the broker). If a trading system generates 3 signals a month, and the monthly subscription fee is $50, then the system's average monthly expenses are 3 x $30 + $50 = $150. Now, if you intend to invest $5,000 into this options trading system and from the history you see that this system may deliver 10% ($500) profit per month in average, then you may assume that you will put 7% ($350) per month into your pocket.
Naked options trading is very risky - many people lose money trading them. It is recommended contacting your broker or investment professional to find out about trading risk and margin requirements before getting involved into trading uncovered options.