LONG ANSWER
Don’t focus on the money
This question is high on the FAQ list and in the minds of many aspiring traders as, not unreasonably, it’s what attracts many of us to trading in the first place. However, as many commentators have noted, financial gain is merely a by-product enjoyed by good traders, it’s rarely their prime motivation for doing it. Certainly, if you start your trading career based on a need to make £1,000s per month or per annum, you’re at an instant disadvantage. To focus on the money while trading will distract you and, almost inevitably, lead to costly mistakes. You’ll be too caught up in how much money you’re making or losing to trade in the calm and disciplined way that is required in order to enjoy success in the long term.
Aspire to trade well – and the money will follow
Sales people who only focus on the commissions rarely make good sales people. It’s only when they focus on the wants and needs of their prospects and how best to serve them that the sales start to roll in. And so it is with traders: they have to focus on becoming the best practitioners of their art that they can be – not the money they might make. That said, this FAQ will outline some of the key factors that will determine how much – or how little – you can expect to make.
A tale of two photographers
If you turn on a camera and give it to a monkey, sooner or later, it will take a photo. Maybe lots of photos. Given what passes for art these days, someone will probably argue that the monkey is a good photographer! Obviously, monkeys know nothing about photography and any ‘good’ pictures they take are the result of luck and not skill. If you could understand monkey talk, how would you answer a monkey photographer who asks: “realistically, how much money can I expect to make doing this?” And if a 1st class honours degree graduate of photography from the Royal College of Art asks their course director the same question, what do you think the answer might be? The two answers range from - probably nothing in the case of the monkey - to, potentially, millions in the case of the RCA graduate.
. . . What’s this got to do with trading?
Well, the monkey won’t lose any money, beyond the cost of the camera. Unfortunately, the same cannot be said for traders. Why? Because, if you don’t understand the markets, the risks involved or how to trade well, you’re very likely to end up as a net loser rather than as a net gainer. Without a doubt, there are a lot of trading ‘monkeys’ out there who, inevitably, help to maintain the alleged failure rate of around 90%. So, in answer the question, at one extreme you could lose all of your capital, your house and your partner and be declared bankrupt. At the other extreme, you could be eye wateringly wealthy. To try and narrow the range down, this FAQ will assume that you are closer to the RCA graduate in the analogy above, rather than the monkey; i.e. you know the markets, the risks involved (and how to manage them) and how to trade. You have a written trading plan that you have back tested and forward tested until you’re blue in the face! The spectrum is still ludicrously wide and needs to be narrowed down further. To help us to do this, two key factors need to be considered when determining the size of potential gains or losses. They are the market(s) that you trade and the size of your account.
Liquid Markets
Some markets are highly ‘liquid’, enabling traders to trade in ‘size’; others are not. A very liquid market is one that attracts a lot of participants, particularly commercial interest – e.g. banks – who have very deep pockets. This is important because it enables traders to buy an instrument at a specific price, certain in the knowledge that there will be someone willing to sell to them at that price. Conversely, there will be traders willing to buy from them as and when they want to sell. An example of a market that tends not to be very liquid - i.e. ‘illiquid’ - is the ‘penny stocks’ market, so called because the share price is less than $0.10. Often, these are small companies that are not listed on the major stock exchanges like the LSE or NYSE. In theory, with $1,000, a trader could buy 10,000 shares priced at $0.10. If the price doubles to $0.20 then, on paper, they’ve doubled their money. However, finding prospective buyers to sell to in order to turn the paper profit into hard cash might not be so easy. By contrast, in normal market conditions, buying and selling 10,000 shares of a stock like Microsoft will be straightforward, as so many people trade it every day. Broadly speaking, its perceived value and the amount it rises or falls, will have little impact on your ability to enter and exit trades at the prices you want. (For more on the pitfalls of trading penny shares, see 'Useful Links', below.)
ES, YM & size
When traders talk about trading ‘size’, they are referring to the number of futures contracts or number of shares traded. For example, let’s take the ES - the e-mini futures contract based on the S&P 500 equity index. The ES is a highly liquid instrument, enabling traders to trade large size, unlike its sibling contract the YM, based on the Dow Jones Industrial Average. According to official CME figures for June 2010, 61,258,075 ES contracts were traded, compared with just 3,688,697 YM contracts. So, all things being equal, if you’re an index futures trader and you want to trade size, you’ll opt for the ES in preference to the YM. Equities traders have to gauge the liquidity of the individual stock when determining how many shares to trade. The penny stocks example above illustrates that you don’t always need a large account in order to trade a lot of shares, but you do need liquidity.
Volatile markets
The bedfellow of liquidity is volatility. This refers to the amount an instrument moves within a specified time period, e.g. an hour, day or week. A common mistake made by novice day traders is to trade highly liquid stocks without taking into account of their volatility. This is ‘monkey’ trading and results in the demise of many wannabe day traders. If you propose to trade large size of very volatile instruments, you’ll need a very large account indeed, as you’ll need very wide stops. And trading size with wide stops is potentially very, very costly. Another rule of thumb is that the more liquid a stock is, combined with a relatively low share price, the less volatile it tends to be. Microsoft in the U.S. is a good example of this, as is Vodafone in the U.K. In order for traders to make a good profit from small price movements, they have to trade large size. This principle applies to all Forex traders. That’s why an intra-day move of one cent in the value of the U.S. dollar is regarded as huge!
Small account + large size + volatile instrument = monkey trading
Generally speaking, the ability to trade size tends not to be the main concern for most retail traders, because their accounts aren’t big enough for it to be an issue. However, what is an issue is the exact opposite; their accounts are too small. Trading volatile markets in too much size with a small account is a recipe for disaster. It’s another monkey error made by novice traders who focus on the potential gain, as opposed to the potential loss. For example, the ES can move 20 points in one day. If you’re trading say, fifteen contracts, that’s a profit or loss of $15,000! Great if it’s the former and a bummer if it’s the latter! Even if you’re happy to risk 5% of your equity on any one trade (not recommended by the way), you’ll need an account funded to the tune of $300,000, in order to comfortably take a hit this big and to stay within your 5% risk parameter. Many brokers advertise margins as low as $500, i.e. you only need $500 in your account per contract traded. So, in theory, you’d only need $7,500 in your account to trade fifteen ES contracts. Don’t be lured by this – it’s financial suicide. You’re far more likely to ‘blow up’ – i.e. lose all your money - than you are to end the day in profit. The index would only have to go against you by ten points and your entire account would be wiped out in a single trade. The issue of account size is expanded upon in another FAQ:
How Much Money Does a Trader Need to Start Trading?
Think percentages – not in $ amounts
The size of your account is critical in determining how much money you’ll make. Rather than thinking in pound or dollar amounts, it’s preferable to think in terms of percentages. On the face of it, a trader who makes $10,000 in one month is doing really well. Wow, $10k in one month! However, if they have a $1 million account, this only represents a 1% return. Suddenly it doesn’t sound quite so impressive. Whereas, a trader who makes the same amount with a $100k account has made a 10% return. That’s much more impressive. As a rule of thumb, and for reasons not covered here, it’s easier to make impressively big gains on very small accounts (say $1,000 or less) than it is on large accounts (say $250k or more). Equally, it is usually true to say that the bigger the return, the greater the level of risk incurred. So, be very wary of traders who claim to have doubled their account in a matter of days or weeks. Most of them are only able to do this by assuming massive levels of risk and exposing most - or all - of their account to catastrophic loss, such as the example above of the trader with a $7,500 account trading fifteen ES contracts.
Risk & Money Management
Central to your trading plan will be your risk and money management strategy. Risk management focuses on the steps required to minimise losses, while money management focuses on the steps required to maximise gains. Central to both these objectives are two simple ratios which, between them, enable traders to create a ‘positive expectancy’. They are:
The Success Ratio
Out of any given sample, what is the total number of winning trades, relative to the total number of losing trades? This is called the success ratio or win:loss ratio.
The Profit Ratio
This is the average £’s won on winning trades, relative to the average £’s lost on losing trades. This is called the profit ratio and is sometimes referred to as the ‘Sharpe Ratio’, although this is technically incorrect.
The important thing to note about the success ratio is that it is not necessary to have more than 50% winning trades to have a profitable trading strategy. Indeed, some of the biggest names in the industry utilise strategies that are profitable only 30% - 40% of the time. For more information on this and the two ratios, along with what positive expectancy means, please refer to the
Essentials Of First Steps Sticky.
Putting it all together
For the sake of argument, let’s say that you’re a day trader and that your strategy as detailed in your trading plan indicates the following . . .
• A success ratio of 1 : 1 or 50%, i.e. half of your trades are winners and the other half are losers.
• A profit ratio of 1.5 : 1, i.e. the average profit on winning trades is one and a half times as large as the average loss on losing trades.
• Risk of 1% of your account equity on any one trade which, for the purposes of this example, will also be the size of the average loss. In other words, losing trades lose 1% of the account value and winning trades make 1.5% of the account value.
• You average 4 trades a day.
• Based on the above, i.e. two losing trades at 1% and two winning ones at 1.5%, you have a net daily profit of +1% of account equity. This equates to 5% per week, 20% per month and 240% per annum.
On a $5,000 account, this will produce profits of $50 per day, $250 per week and $1,000 per month. On a $25,000 account, it will produce profits of $250 per day, $1,250 per week and $5,000 per month. On a $100,000 account, profits of $1,000 per day, $5,000 per week and $20,000 per month. Please note that these stat’s are purely for illustrative purposes only. Your actual figures will, inevitably, be very different.
On the face of it, these stat’s sound as if they’re easy to achieve. On the contrary, they’re not. To make 1% per day, day in and day out, consistently over the long haul will require a huge amount of effort and commitment. It will be very difficult to achieve and harder still to maintain. Additionally, costs have not been taken into account. You’ll have to pay commissions, fees and charting subscriptions etc. – all of which mount up. In his book ‘Come into My Trading Room’, Dr. Alexander Elder suggests that a realistic goal for a newbie trader is to break even after expenses in the first year, equal the return you would get from a Building Society account in the second year, and to aim to double that return in the third year. Members of forums like this one are quick to point out that no one enters the trading arena to endure returns as dismal as these. Of course, they’re quite correct; the 20% returns per month - or better - outlined above is what we’re all here for. To be fair, some traders not only achieve returns like these, they actually do much better than this. It’s definitely possible, great wealth can be yours. Just don’t kid yourself for one minute that it’s going to be easy. Good luck!
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