Sunday, June 5, 2011

Small Account Strategy

Trading a really small account is problematic. By small I'm talking about a couple hundred dollars or so, the kind that your kid might open to invest their babysitting money because the banks aren't paying interest on savings accounts anymore.

Firstly, there's the issue of whether the brokerage will even open the account. Many brokerages don't want to know you until you have $3,000 and will simply decline to open small accounts. And Even if you are permitted to open a small account, many brokerages have low balance fees that are designed to skunk you out of your money.

Then there is the issue of commissions. Because of commissions, small account traders tend to trade way too big. Even 5 - 6 shares of most any reasonable stock represents a huge risk to a small account. Even with a winning pick such a position will need to produce very high, percentage-wise, returns to overcome the commissions. Otherwise, small account traders will buy penny-stocks which have a dismally poor track record because they tend to be companys that are going out of business.

However, it is possible for a small trader to get a foot in the door. Here's how:
  1. Open a TD Ameritrade account. They don't have low-balance fees nor do they have minimum balance requirements to open. So far as I know this is unique in the industry.
  2. Sign-up for TD's commission-free ETF's. An ETF (Exchange Traded Fund) is a mutual fund that trades like a stock. This is advantageous because you can use good-til-cancelled orders to take profits at the moment your target price is achieved, not at the close of the day (or more likely day-after if your'e not checking intraday) as with a traditional mutual fund. TD offers a menu of about 100 ETFs that you can purchase for no commission, provided that you hold the shares for 30 days. There is a special waiver you need to fill out that says you understand about the holding period and the consequence for breaking it: a $20 commission on the early sell - roughly what TD would collect for the entry/exit round-trip on any other equity.
  3. Select commission-free ETFs under $50 that pay a dividend. There are a goodly number of these, such as PCY and JNK that pay dividends monthly and have fairly stable prices.
  4. Buy 1 share. Yes, you can buy just one share and there is no shame in it. Size=risk, so take advantage of the fact that you can trade this small. Also, the days of penalizing odd-lot (not a multiple of 100) transactions is long gone. 
  5. After 30 days enter a sell order. After 30 days enter a good-til-cancelled limit order to sell the share when it achieves a 10% gain. Defining your profits is the big secret to profitable trading. I can't tell you how many times I and my fellow traders have seen a profitable position reverse and go negative. The smaller your target, the faster it will be achieved. Since you have no commission overhead to cover why not take profits a soon as you can. Experiment - maybe 5% or 2% is more optimal.
  6. Lather, rinse, repeat. You should buy several different ETF's, if they are a growth fund then don't look for dividends so much.
Caveats:
  1. Avoid stop-loss orders. The point of this strategy is to size the position small enough to avoid needing stop-loss orders, which have their own set of problems. ETF's are comprised of many different underlying equities and therefore the chances of one going to zero is very small.
  2. Avoid adding-on to the position. The thirty-day holding period applies not only to the add-on shares but also to previous shares purchased. If you must add-on, then, cancel any previous sell orders and be prepared to wait-out another 30 days on the whole position.
  3. Keep 5-10% of the account in cash. The cash position cushions a falling market and gives you some ammunition to buy after the fall.
  4. The usual disclaimers: These investments can lose money and are not FDIC insured. Your milage may vary. Swim at your own risk.
I have verified that all of the above works because I use this strategy to invest on behalf of a certain relative of mine. We opened the account with $250 earlier this year. There are currently 8 single-share positions in the account and it is currently worth about $265.


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