Money Management
figure 28.15 The Minimum Initial Capital Rule.system. The system starts off with initial capital of $10,000. Assume that all trades
were executed using single fixed lots without compounding profits and that the
balance curve is plotted on a linearly scaled chart. Would a trader who starts off
trading this system with an initial capital of $10,000 be profitable?
The trader would in fact be putting his capital at risk by trading such a system
as the largest absolute dollar drawdown was significantly in excess of $10,000,
as can be seen from the amount of decline in the balance curve as indicated in
Figure 28.15. Therefore even though the system may prove to be consistently prof-
itable over the long term, a trader may still lose all of his or her capital should the
drawdown occur early on in the trades, where the trader has insufficient capital to
withstand such volatility within a profitable and winning system. This is referred
to as the minimum initial capital rule, where the minimum capital required must
be at least equal to and preferably greater than the largest historical drawdown
experienced by the system.
But there is another issue. Even if the minimum initial capital rule was satis-
fied, this balance curve does not account for the actual equity action in the system.
Equity is simply the total balance and running profit and loss experienced by the
system. Unfortunately, the balance only tracks the profitability of all closed trades.
It does not account for the profitability of open positions. See Figure 28.16.figure 28.16 Current Net Value Reflected in the Account Equity.