WHAT MAKES THE market so undeniably fascinating is that at any moment, the bull’s case is just as compelling as the bear’s. So let’s say we’ve hit the bottom, or at least a bottom worthy of trading from the long side. After all, the averages have rallied strongly since September, and given that perky performance and the examples of history, there are plenty of reasons to believe the market’s next move could be higher.

Which way you trade usually isn’t as important as what you trade. And there are choices galore.

You could buy stock in IBM (IBM), General Electric (GE) or any of the other big stocks that make up the Standard & Poor’s 500, or a mutual fund that will do it for you. You could buy options on the index itself, or an exchange-traded fund holding stocks that make up the index. You can even buy options on exchange-traded funds that hold stocks that make up the index. Can you say overkill?

Having a good investment idea is one thing, putting it into practice is another. Think Sun Tzu: Every battle is won or lost before it is even fought. No matter how good your analysis is, choosing the appropriate instrument relative to your capitalization is a big factor in determining the outcome of the investment battle. So here’s a look at what might be the right instruments for relatively small investors with varying portfolio sizes.

Under $2,000
Although it goes without saying that you should never speculate with anything but risk capital, there are still plenty of people who insist on trading with money they can’t afford to lose. What usually sinks them isn’t their stocks, but their psyches. Their big losses come from the fear of taking small ones. So just because you can get into the market with a few hundred dollars doesn’t mean you should. If you’re sitting on fragile finances — especially high consumer debt — you might just find the best trades are the ones you don’t make.

My first trades came in the form of strategically buying certificates of deposit in high school. Before Bankrate.com or other online guides, I spent many afternoons calling S&Ls all over town looking for the highest rates on CDs and other cash equivalents. Most people with investable assets under a couple of thousand dollars will still find managing their cash to be the best and most prudent move — at least until they’ve built a more substantial pile.

But having a small stake doesn’t mean you can’t have a strategy. By staggering CDs or allocating between short- and long-term bond funds, you become a bond trader, choosing between liquidity in the short term or higher rates for longer commitments. Watch the yield on the most recently auctioned 13-week Treasury bill as an indication of short-term rates. When the yield is falling, buy long-term bonds or CDs. When it begins to rise, keep your duration short by using money markets or one-month CDs.

$2,000 to $7,000
With a $2,000 or $3,000 account, I would encourage you to focus primarily on no-load mutual funds. Why not individual equities? Well, although stock commissions have come down since the early 1990s, trading costs still affect the bottom line. The smaller your account, the bigger the impact. Even at $5 a trade, that’s still $10 a “round turn.” On a $2,000 account, just the commission off your first 20 trades will cost you 10% of your equity. That’s a lot of ground to make up just to get back to even.

Add in the impact of taxes, and the mathematics of buying stock with a small account just never seem to work out. At $60 a share, $2,000 will buy you approximately 33 shares of Amgen (AMGN). If the stock rises to $65, you’ve made approximately $165 in paper profits. Chop off 10 bucks for commission and at least another 20% for capital gains, and we’re talking barely $125 profit, rather limited upside given the risk of holding such a concentrated position.

It’s true that many brokerages will open a stock account with a mere $500. But I think attempting to trade when you’re that woefully undercapitalized is next to insane. From experience and countless observations, I have found that it’s far better to wait until you’ve built up a larger pile.

But mutual funds, and especially no-load funds with low expenses, present a compelling investment opportunity for traders with between $2,000 and $7,000 in investment capital. The two biggest advantages are low minimum-balance requirements and minimal transaction costs. Many funds still charge loads (read: commissions), but thanks to healthy competition, there are thousands of no-load options available for almost any investment objective.

This diversity is where the mutual-fund option really shines. Bullish on Japan? How about emerging-market bonds? Whether it’s Latin America or the long bond, mutual funds allow you to play almost any side of the financial markets, even the short side. Both Rydex and ProFunds are among the mutual-fund companies that offer mutual funds that sell short, aiming to profit from a declining market.

And most no-load funds are a bargain. You can use low-cost index funds to allocate assets, or opt for an actively managed fund run by a top manager. For $10.28 per $1,000 (1.28%), you can hire talented and experienced experts like Ron Muhlenkamp to pick stocks on your behalf for a whole year. Now there’s a thought! Instead of betting on the horses, consider playing the jockeys instead.

$7,000 to $15,000
With $7,000 on up, more sophisticated traders can begin using conservative options strategies like buying calls or puts. Options are a nuanced and fascinating way to bet on a stock’s direction with limited risk and potentially unlimited upside. They are traded on almost everything, but because individual equities tend to be more volatile than indexes, I’ve always found it easier to speculate using options on individual stocks rather than broad-based indexes like the S&P 500 or S&P 100. Beginners should surf over to the Chicago Board Option Exchange’s home page and start reading. Because options involve an entirely different terminology and risk profile, I’d also recommend a few good option books plus some paper trading before you start swinging for the fences. And remember, you do this only with money you can afford to lose, not with Jimmy’s college fund.

Individual stocks also become more feasible with at least a $6,000 or $7,000 account. Commissions don’t have such an impact on your overall equity, so you’re more able to build positions slowly rather than buy them all at once. I use the rough guide of one position per $5,000 of capital, so if you’re starting with $7,000, don’t buy 20 different stocks. Focus on your best idea, use disciplined money management, and watch every move the stock makes.

$15,000 and up
With $15,000 or more, traders safely begin small-scale futures trading. Although they are often associated with agricultural commodities, futures contracts are traded not just on soybeans, but also the S&P 500, plus everything from natural gas to the Nasdaq. In recent years, many of the exchanges have introduced mini contracts designed for the small speculator, allowing even the sophomore-sized Soros to bet on corn, currencies and stocks. But because of the inherent risk of dealing with high leverage, I can’t stress how important it is to be adequately capitalized before trading anything…especially futures. As the old joke goes, the easiest way to make $1,000 in the market is to start with $5,000 and one can’t-lose idea.

From mutual funds to stocks, cash equivalents to futures, there are tons of ways for aspiring traders of every size to participate. So if the shoe fits, wear it. Because nobody knows the market’s next move, trading is an exercise in probabilities. And by focusing on the products that are most appropriate for your account size, you are ensuring that the inevitable losses that come with trading will merely ding your overall equity…not shred it.

– Originally on Oct 22, 2001 by Jonathan Hoenig