Allocation of Capital

At the very least, in order to implement an algorithmic trading strategy, you will have to post margin with a broker.  Margin is simply the amount of money the broker requires you to have sitting in your account, in order for you to trade.  The required amount depends on how much you want to trade.  In equities, you have to have some fraction of the value of any stocks you hold (in either a short or long position).  For futures, your broker will specify the amount of money required to open (and then a different amount to hold) a single futures contract position (again, either long or short).  As a general rule, you should post more margin than is required, because if your positions lose value, your broker may invoke a margin call against you, and close some of your positions automatically.  This usually works out badly if you are trading, as brokers do not have to get you a good price when they close your position.  From their point of view, they are simply carrying out risk management, trying to prevent their clients from losing more money than they can afford to pay.   (Actually they normally advise you that you have exceeded your margin requirements and give you a grace period to put more cash or collateral into your account before they close positions, so it's not quite this bad unless you fail to communicate properly.)

But even beyond margin requirements, it is very convenient to allocate some amount of capital to an algorithmic trading strategy.  In other words, you need to associate an amount of investment money with the strategy.  This should be a pool of money that you have available, that you can afford to lose, and that you set aside when running the strategy.  At the very least, it should be large enough to cover margin requirements.  In many cases it may be more.  As a general rule, you would probably scale the size of the trades made by the strategy proportionally to the allocated capital.  Furthermore, it would be common to reinvest profits and deduct losses directly from the allocated capital.

This is a useful thing to do because

(Actually many people take a slightly different, but approximately equivalent approach.  Instead of thinking of an amount of capital allocated to a strategy, they give it a risk allocation, that is, they place a limit on the standard deviation of the profit/loss over a period of time.  If the strategy starts losing particularly large amounts, the standard deviation will become larger and the idea would be to scale the strategy down in response.)

Next: Performance Measurement            Back to Index