May 12, 2011 (Revised) - by Christopher Smith
Realistic Trading Expectations
Disappointment and Overleveraging Your Portfolio by Setting Realistic and Achievable Profit Targets
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 even nirvana, is easily within their grasp.
Unfortunately, these unrealistic expectations are often reinforced and even fueled by the popular media and
aggressive marketing designed to sell investment and trading 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
A prudent trader limits the risk on any one position. Typically, 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 realtively oversized positions in comparison to the capital allocation
appropriate for larger accounts, and any profits, or losses, reflect that on a proportionate basis.
I will also not that I have no objection to a trader risking 5% or 10% of their account on a single trade when that
account is small. The reason for a looser risk tolerance is because 10% of a $5,000 account is $500.00.
It's not a meaningless sum, but it is also not so significant that with a proper savings discipline that it could
not be replaced in a matter of months. Not so if we are talking about a $500,00 account where a 10% loss
equates to $50,000 of investment or trading capital - an amount not likely to be replaced quickly through
To maintain the high rate of growth in a trading account as it begins to grow, 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% or less of their overall account. If they adhere to this 2% rule, a
smaller proportion of the account will be exposed to the market or they will need to increase the number of active
positions to keep their account fully invested so as to maintain the previous rate of growth. However,
simultaneously monitoring and managing 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 the size of their positions. They might move from $500.00 positions to $1,000.00 positions as their
account grows from $5,000.00 to $10,000 in size.
Experiencing losses is inevitable, however. Every trader will also experience a losing streak - a series of
losses one-after-the-next. The larger position size risks financial destruction in the event of even 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 other interest bearing investment, or invested in longer
An effective trader can average 20% to 25% per year. An exceptional trader might experience 30% average annual
returns. While these numbers may sound paltry in comparison to what the marketers and media pundits may discuss,
these are in fact stellar returns when achieved year-on-year and the power of compounding is permitted to work its
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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