How much capital to trade with? Demystifying Capital Allocation

The retail participation in the Indian markets has grown exponentially after covid, resulting in a mass influx of people into derivatives trading. A lot of people associate trading with easy money, which is far from truth. This perception isn’t new but it is being sold in such a way by trading gurus, that people think of trading as a low effort cash printing machine.

A lot of people start their trading journey with a capital of less than ₹30,000, which in itself isn’t a bad thing but their level of expectation is far from rational. They mostly expect returns in absolute money terms rather than in percentage which makes their expected returns unreasonable when compare to their capital.

Optimal capital for trading:

It’s not like you can’t trade with a lower capital, but it won’t be enough for a sustainable trading journey if you are planning to be in the market for a reasonable time. While the capital requirement in itself varies for different strategies, ₹50,000 is a good amount to start with for option buying, and ₹1,50,000 and upwards for option selling. The stated amount would be a good minimum capital to trade with.

The reason for avoiding capital figures like 15,000 or 20,000 is they can’t be used to trade for longer periods if losses occur. Experiencing a loss of ₹5,000 on a ₹20,000 capital and the same on a ₹50,000 capital has different psychological effects on the same person. Moreover, different strategies require different margins.

Generally, a bull call spread has a margin requirement of around ₹30,000. Both short straddle and strangle has a margin requirement of around ₹1,00,000. So, a person entering the derivatives market with a capital of ₹50,000 can take option buying trades with stop losses commensurate with their risk profile.   

Capital Allocation:

A market participant having adequate capital to trade with, has to sought out the capital allocation part of it. Allocating capital depends on the nature of instruments and strategies one is dealing with. In general, out of 10 trading days only 3 days are trending and the rest 7 are sideways. The reasonable split of capital in terms of options should reflect this nature of the market. So, allocating 80% of the capital to option selling and the rest 20% to option buying would be a rational split for the average market participant.

The 80/20 split is based on the pareto principle which states 80% of your returns comes from 20% of your trades. It is also an effective risk management strategy where parking 20% on directional trades and the rest on non-directional trades would be better for the average new retail participant.