FOREX UNDERCAPITALIZATION RISK

UNDERCAPITALIZATION RISK
Insufficient initial capital invested into trade is the first mistake made by a
majority of newcomers, and it often turns out to be their last mistake.
I have witnessed many cases of full loss of capital invested into currency
operations during the first month, weeks, days, and even hours. The
invested capital is lost before a novice FOREX trader has time and an opportunity
for learning.
This happens for a few key reasons. At the beginning of a career, a
new FOREX trader has neither sufficient knowledge and experience nor the feeling
of danger or risk limit that should not be surpassed. Also, at the very
beginning, there are some errors that could be avoided with the proper set
up before conducting business. One of the frequent initial mistakes is insufficient
investment in FOREX trading operations. Consider the condition when
the average daily oscillation amplitude of the main currency in a percent
ratio is comparable to the margin offered to the currency investor by
banks, dealers, and brokers. (It is common nowadays to provide the
trader with such a condition when the initial margin does not exceed 2 to
4 percent of the size of the contract for the daily trade.)
If the currency oscillates 1 to 1.5 percent on a daily average, the loss
of a larger part or even the entire trading account within just a couple of
days is possible. I must mention that most novice traders partially realize
risks they will have to deal with on the currency market, but are not always
capable of precisely formulating and evaluating them. Therefore,
they often undertake incorrect actions for lowering them. Logical thinking
dictates that the simplest way of lowering the risk of potential losses is by
investing the minimum possible amount into FOREX trade. At the same time, the
idea and the plan are to increase the investment later as the necessary experience,
knowledge, and skills are acquired. From my experience, this
approach to lower the risk is virtually ineffective and even harmful. The
situation reminds me of one of my favorite anecdotes: A commission arrives
in a psychiatric hospital to inspect the facility. The commission
members see an empty swimming pool into which the patients are diving
from the diving board. The commission members ask one of the patients
why they are diving into an empty pool. The patient answers that the hospital
administration promised to fill the pool with water immediately after
the patients learn how to dive.
Usually, most novice FOREX ( Foreign Exchange Market)traders partially realize the risks they will have to deal with on the currency market, but they are not always capable of
precisely formulating and evaluating these risks.
In the same way, many novice FOREX traders try to lower the risk of losses while
they are expecting to acquire sufficient practical experience, in order to
invest larger amounts later on. They don’t understand that a small trading
account actually increases the risk of losses. By artificially decreasing
the initial investment capital, it is impossible to lower the risk. This is because
the size of the trading account and the risk degree of losing some
part of the investment capital are not proportionally related. I will illustrate
this statement with a simple example. Let’s assume there are two
accounts. One of them has invested capital of $5,000 and the other
$50,000. All other things being equal (such as minimum contract size of
$100,000), the initial margin equals 4 percent, and during one trade only,
one minimum contract is operated. It is clear that only after two or three
unsuccessful transactions (each resulting in a loss of an average of
$1,000), the smaller account is practically inoperable and requires replenishment
in order to continue participation in the market.
The larger account in this situation remains absolutely sufficient for
further operations. Restoring the loss is easier than in the small account.
Equalizing the chances to win with large and small accounts is possible
only by proportionally decreasing the minimum contract size for a small
account owner, or by the same proportional limitation of loss size. It is
practically impossible to accomplish either of these options.
The size of the trading account and the risk degree of losing some part
of the investment capital are not proportionally related.
The minimum contract size for everyone who works with a good
dealer should not be below $100,000. It can be said that this amount is a
minimum standard for small individual transactions. By putting short and
tight stops, the trader increases the chances the stops will be triggered
more often and the total loss will consist of many small losses.
Sometimes, novice traders gradually add money to the trading account.
By replacing the losses on the market, they keep the small account
instead of immediately investing the large sum in order to lower the risk.
As a result, considerable amounts are often lost, invested into the market
in small portions. One of the main reasons for these losses is insufficient
capital at the moment when it is most required. Therefore, the most frequent
disadvantage is insufficient initial investment.