We have had recent discussions in our forum and a presentation by Mark Sebastian about realistic returns. We also all get the same advertising from the financial newsletters and trade advisory services that tout the returns they have experienced on their trades. I've never received one of those crowing over a 10% or 13% annualized yield. The numbers are always much more impressive.
So, they must be lying to us. Right? Well, yes and no and before we vilify them for their marketing let's take a closer look.
I want to introduce a concept that we can call "The Spin," which is the art of taking a known truth and "spinning" it to suit your purpose. The art of spinning is used daily by marketers, politicians, and everyone else that wants to win an argument, make a sale, get vote, etc.
Let's take a hypothetical trading service that claims to be up 75% year-to-date. What does that mean? Does it mean that if you had followed their trade recommendations that your account would be up 75% right now? Probably, not. But they said 75%, right? Wanting to get to the bottom of this we might ask for a list of trades and let's say the oblige us and provide a list of those trade recommendations and we find one trade each month that played out like this...
The first let's assume returned 100%, the second had a 100% loss, the third yielded 100%, the fourth lost 100% and then the fifth was closed for a 75% win. The profits from trades 1 and 3 were offset by the losses on trades 2 and 4, and we're left with a 75% yield on the 5th trade. They didn't lie, did they. So, if you had followed their recommendations you would have made 75% on your capital, right? Wrong!
Why would you not have made 75%? The reason is because in order to have had a 75% yield on your account you would have had to invest 100% of your account in the trades. The first losing trade would have wiped you out and you would have had no capital with which to take the other trades.
That's why one of the risk management rules we follow is to limit capital on any one trade to no more than 5% of the account - and less if you have trading capital of any size. So, let's say your account has $10,000 in it and you allocate a fixed $500.00 to each trade. You would have profits of $500 on each of trades 1 and 3, but would give those profits back on trades 2 and 4. On the 5th trade you would have profits of $375.00.
A net profit of $375 on a $10,000 account is a 3.75% yield. That's a 9% annualized yield. Much less impressive than what was advertised, yet the advertised returns were accurate.
But you may be thinking that we only risked 5% of the portfolio on those trades and if we had risked larger sums on each trade that our yield would be larger. That math does not work, because what happens is that as you increase risk in the portfolio you also increase the volatility in the portfolio. As volatility increases yields decrease because you are not able to leverage your profits through the power of compounding.
The purpose of the discussion board thread, the web-cast and now this post is not to sour you on financial publications. What my purpose was in bringing this topic to our community was to inject some reality into the expectations we have for our ability to generate returns through trading. Advertising and popular media presents a very enticing picture but it is a false picture.
Develop a healthy skepticism and realistic goals for your trading. Learn to balance risk with potential profit, and focus upon long-term sustainable growth within your portfolio. The result will surprise you.
P.S. This year I committed to an experiment that has me trading an iron condor on the SPX every month - regardless of market conditions. The purpose of this exercise is to demonstrate techniques for managing risk and prove that with diligent risk management it is quite possible to limit losses while still creating profitable opportunities. This year has not been particularly favorable for iron condors, but we have managed to avoid any significant loss and currently we have what amounts to a 20% annualized yield on capital of $5,000 while risking approximately $4,000 or 80% of the capital - holding $1,000 or 20% in reserve. These trades are followed in detail in the Trading Room, with weekly live webcasts, and real-time e-mail trade alerts issued whenever a trade is placed or filled.