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May 12, 2011 (Revised) - by Christopher Smith
  

Realistic Trading Expectations

Avoiding 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 five years.

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 savings.

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 term holdings.

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 magic.

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.

 

Consider joining us in the Trading Room where we work with traders to help them develop a foundational understanding of options and sound trade management skills.

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