Sunday, September 24, 2006

Risk or Can you make a living from trading

Say you want to make 50k$/year.
And as for so many aspiring traders your account is somewhere between 10k$ and 20k$.
We all know the compounding spreadsheets and it sure appears to be possible. The problem is the risk part, we usually overlook in these compounding examples, which tell us, that in 50 days we will trade a 5k$ account upto 50k$, taking "just" 2 or 3 points ES or Russel a day.
Let's take the 10k$ the 20k$ account size example.
You start trading 2 contracts as so many do.
And as a lot of traders (actually somewhere between 80% and 90%) you will fail after a while.
As I see it, these traders fall for the lure of overleveraging themself, of taking too much risk for their account size.
After trading for a while, your statistics will tell you what you lose on average on a losing trade. And unless you microscalp, it will be usually somewhere between 10 and 20 ticks / trade, so somewhere in the range of 100$ to 250$ loss per contract traded.
For our aspiring trader trading 2 contracts that makes a risk of 200$ - 500$ / trade. Let's take it in the middle, so it's a 350$ / trade risk.
Now we all know, losing trades come often in a row, so you need to decide what is your worst case scenario?
3 losing trades, 4 losing trades in a row? Most likely, if you start trading the risk might actually be 5 or 6 losing trades in a row, but say you have decided after 4 losing trades, you pull the plug for the day.
4 losing trades * 350$ = 1,400$ risk / day
4 red days in a row, sure not unheard of, so our aspiring trader is down 5,600$ on his 10k$ - 20k$ account
Does it happen? Oh yes, I know at least 1 trader, who had this happen to him and it wasn't such a long time ago that that happened to me and I recently wrote about it (more bang for the buck)
For me it meant imposing some strict money management rules and setting the internal margin / contract to 10k$.
This limits the profit potential, but the profits really take care of themself, once you get the losers under control. (At least, if you have recognized your edge in the market)
Most important it means this measure is getting the daily risk under control.
Not the risk in the individual trade, but the overall risk you take every day, because you know you have statistically x% losers, which means you will encounter losing streaks as sure as you wake up every morning.
So does that mean, it's impossible to trade a 10k$-20k$ account so you can take out 50k$ / year?
It most likely is, yes, because the risks you have to take are too high and statistically you will encounter the losing streak, which can bust you.
Therefore, you will first need to trade your account up, living from some other funds or a second income, before you will be able to take 50k$ out of the market on a regular basis.