Tips for Future Money Managers: Notional Funds
In the world of institutional money management you can’t afford to have anywhere near the volatility in your returns that you might on your own account at a retail trader. For example a top hedge fund would look to wind down trading if they were down more than 2% for the month.
In-fact Michael Platt of the hedge fund Bluecrest, is quoted in the book Hedge Fund Wizards, as saying he will cut a traders allocation in half if they lose 3% of their core capital in a year. If they then lose a further 3%, they would be out of a job (for a maximum loss of 4.5% of core capital).
As discussed in the last article typically this means that you would need to reduce the risk on your positions to something like 0.1% for short term trades, or 0.5% on long term positions.
But using this type of money management approach on a retail account might not be all that practical. Yes, you may be able to display that you can manage risk effectively (which is a tick in the box), but you might not attract much interest if you return 12% on a 10K account for the year.
So what’s the answer? Use notional funds.
What are notional funds?
Notional funds is when you fund an account below its full value.
For example you might have 10K in your account, but you trade it like you have 50K. You base your risk management and position sizing off of a 50K account, even though you only have 10K in you actual trading account.
This means you get to display both your knowledge of risk management, and your ability to trade with some size and handle the pressure of having money on the line.
Notional Funding is common practice in institutional money management
Notional funding is actually a very common practice in institutional money management.
Investors in funds want to be efficient with their capital, so they will often use a notional amount of funding. For example they may put 5 million with the fund, but have the fund trade it like its twenty.
It’s good for you as a trader to understand this it gives insight into how investors think. As mentioned its volatility of returns that are important as well as real returns, and notional funding is one of the main reasons why.
How to use notional funds without breaking the bank
This is all good, but you don’t want to necessarily throw 10k in an account and then trade it like its 50 or 100K.
The problem with this is that even if you risk 2% of your notionally funded 100K account a month, it could leave you with 2K hole in your real money account.
What I suggest you do it take it slow, and start by not using any notional funds for the first 1-2 months. Once your account is in profit then you can risk the profits (i.e. by using markets money) to trade a larger notional size. For example if you are up $500 after the first two months you can then trade a 25K notional account (risking the $500 you have made). If you have a losing month, then you can go back to trading a smaller size again and repeat the process.
The benefit of this approach is it shows that you know how to protect your core capital, but that you are willing to trade with size when things are going well. This will help get your into seed funding programs to start your money management career.