Trading Expectations

You have read a few good trading books, paper traded a virtual account, and jumped into the markets with real money, then the worst thing imaginable happened.  You made money... 

When a novice stock or option trader sees early success they understandably experience excitement and often a sense of euphoria.  It does not take them long to begin extrapolating from their early successes how long it will take them to achieve their life's financial goals. 

Stock and Option Traders, It Is Now Time To Wake Up And Smell The Coffee...

Every so often a new trader will question what they can reasonably expect to see in the way of returns from stock or option trading.  When so confronted, I often find myself being the 'wet towel' or the proverbial 'rain on the parade' when I explain that the short-term returns they experienced cannot be relied upon as an accurate indicator of future earnings.  Most often I am met with resistance, sometimes rudeness, but it is understandable because they so badly want to believe that financial salvation, perhaps nirvana, is easily within their grasp.

Unfortunately, these unrealistic expectations are often reinforced and even fueled by marketers hoping to sell their products.  The reality is that trading is a difficult business and that the actual returns are typically much less exciting than what we might otherwise like to believe are possible.

Implementing Sound Money Management

Occasionally, the person asking the question has recently doubled their account in a short period of time and questions why it is not realistic to believe that they can continue doing so as the account grows in size.  If they can continue to double their account each year, they calculate that their $5,000 account will exceed $150,000 in five years. 

A prudent trader limits the risk on anyone position to no more than 2% of their overall account.  Often, a trader will not risk more than 1% of their available assets.

When trading a $5,000 account, this tight position sizing is not realistic because trading $100 positions is inefficient.  Commissions, slippage, and attendant costs consume potential profits.  Consequently, when starting with a small account you are invariably trading oversized positions and any profits, or losses, reflect that.

To maintain the high rate of growth in your account, a new trader will need to continue increasing their position sizes.  What they should be doing is maintaining a static position size until each position represents approximately 2% of your overall account.  If they adhere to this 2% rule, they will then need to increase the number of positions to keep their account fully invested and maintain the current rate of growth. However, simultaneously monitoring 50 positions is not something an individual can do effectively.

The Pitfall Of Early Trading Success

Early trading success tends to fuel enthusiasm, but it also leaves novice traders with an unrealistic impression of what is reasonably possible. 

As their small account grows in size, they often want to continue to see the rapid rate of account growth and begin increasing their positions.  Experiencing losses is inevitable and the larger position size risks financial destruction in the event of a short losing streak. 

Novice traders who experience early profits are especially at risk.  Their early success has allowed them to avoid grappling with the question of how to handle losses and eventual losing streaks.

Ultimately, a trader's job is that of a risk manager. The winning trades will come, but it is how a trader handles the losers that will determine their long-term results.

Setting Realistic Trading Expectations

As a novice trader, your goal should be to gradually reduce your relative position size until the planned risk represents no more than 2% of your trading capital.  With an increased account size, you will likely find yourself trading only a portion of your capital at any given point in time.  In other words, you will not be fully invested.  Idle cash can be placed in a money market account or invested in longer term holdings.

An effective trader can expect to average 20% to 25% per year.  An exceptional trader might experience 30% average annual returns.  The goal should be to grow your starting capital to a point where you no longer need to risk more than 2% in any one position.

By incorporating sound risk management into your trading, you will be better able to withstand the inevitable losses and return to profitability.  Establishing a realistic expectation of long term performance will help keep you from overextending your capital once your account begins to grow.

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