Trading Profits
The market opened higher, and the trader closed out his position. He remembered the well used adage “You can’t go broke taking a profit” as he rationalised his decision to himself. He forgot the disturbing corollary – you can’t get rich either. This article is about how to evaluate and maximise your trading profits (irrespective of whether you trade stocks, futures, forex or options) by learning about two important facts that are often not discussed.
Fact 1 - It isn’t the individual trade that counts – it is the equity curve
Our culture is all about the big quick one-off win, but trading is not like that. It is a business like any other.
Some traders will pat themselves on the back when they make a quick profit. Perhaps they make a 10% return on their capital in a few days. They then annualise this profit to give themselves a staggering return over the year.
This ignores two things. Firstly, profit on an individual trade is almost meaningless, especially if the trade was lucky rather than part of a system. A lucky trader may have taken that profit quickly because of greed and fear. With a proper trading system determining their exit points, they make have made 20 times as much.
It is the return over a lot of trades (expectancy) that counts. For an experienced trader, this will include a few big profits, and many small losses. The profits compensate for the inevitable losses. The inexperienced person usually has small profits and many larger losses.
Secondly, it is artificial to annualise a few trades. If I made 5% in one day, does this mean that I will make 1500% in a year? No. The long term return can only be measured for a lot of trades. In the shorter term, it is the smoothness of the equity curve that is more important. This indicates whether losses are under control and whether the trader is making some consistent profits.
Fact 2 – Your return must be measured against the return from other opportunities
When I worked in a bank’s treasury, we did some interesting analysis. We looked at the returns for traders compared to the capital they used, and risk adjusted the returns. The result was that most traders did not outperform the market, as they thought – they simply earned the market rate of return and their returns were purely from taking more risk.
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