Sunday, August 19, 2007

How Much Should I Be Making Trading Stocks and Options?

In my conversations with retail traders, I find that they have very high expectations for their returns. I suspect that the expectations are often unrealistic and can lead to some poor decision making. A couple of years ago while teaching a trading seminar, I had shown the class a spread trade I had entered on QQQQ. The Q's have strike priced $1 apart and I had entered a credit spread in which the market paid me 20 cents a share at entry. If you are unfamiliar with options, you don't need to know the specific mechanics to get the gist of this article, I think my point will become clear as I discuss the simple math. In any event, I had entered a 20 contract spread so I was paid $400 before a small commission at entry. Since the strike prices were only $1 apart, and since the market had already given me 20 cents, my total risk was 80 cents. That is a return on risk of 25% (20 cents/80 cents), and since the options were scheduled to expire in just 3 weeks, I had a potential return of 25% in 3 weeks. Personally, I don't think that 25% in 3 weeks is a bad return.

One of the seminar students thought that was just a terrible trade because I only got 20 cents ($400). He said he wouldn't bother with a trade for only 20 cents. He said he would not think about entering a trade unless he got at least 50 cents. I asked him what he thought a good annual rate of return on risk might be and he replied: "20%." Well, I had just showed the class a trade where I stood to enjoy a 25% return in three weeks, but the student still didn't understand. He was hung up on 20 cents, yet I believe that $400 extra a month would mean a great deal to many people.

If I look at the $10 Trader, for example, I see a number of relatively small wins. Say, for example, that I am trading $10 and under stocks. What if I were to gain 50 cents a month. Does that meet reasonable expectations or not? If I were trading 100 shares, that would only bring in $50 before commissions (and commissions could be $20 or $30 or more). What if I bought 1000 shares of a $5 stock and made the same 50 cents? Now I would have made $500. In either case, however, my return would be 10%. Is 10% a month a satisfactory result? If a trader expects to make $500 a month, is it likely he can do that with a 100 share trade of a $5 stock? Clearly, that would require a 500% return and while those may occur every so often, it is not something one would reasonably expect every month. On the other hand, could a trader reasonably expect to make 10% a month? Undoubtedly, that would be a much more attainable goal than thinking he could make 500% a month.

When I ask seminar attendees what they think is a good annual return, the answers usually range from 10% to 20%. What do you think is a good annual return? When you make a trade is your expectation in line with your definition of a good return? Suppose you are trading $5,000 of risk money. How much would you reasonable expect to make in a year? How much in a month? What risk are you willing to undertake to attempt to achieve that end? Once again, let me refer you to my archived article on business plans and suggest you formulate your own.

In my estimation, it is critically important to have a realistic expectation for your trading results. Unrealistic expectations lead to frustration and disappointment. Success in trading often comes in many small bites rather than a single killing. The single killings do occur, but I think it is much easier to succeed taking the smaller bites.

Bill Kraft, Editor
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