The Economics of Trading
In This Week’s Issue:
- Stockscores Webinar – How to Create a Trading Strategy
- Stockscores’ Market Minutes Video – Beware of Parabolic Trends
- Stockscores Trader Training – The Economics of Trading
- Stock Features of the Week – Abnormal Breaks
Stockscores Free Webinar – How to Create a Trading Strategy
Stockscores Founder Tyler Bollhorn will show the steps and thought process to create a new trading strategy, whether you are looking to day, swing or position trade.
Click here to register. http://www.stockscores.com/trader-training/upcoming-events/#events
Stockscores Market Minutes – Beware of Parabolic Trends
This week, a look at what a parabolic trend is in stocks or markets, and the importance of understanding how they affect your trading. Plus, my weekly market analysis and my trade of the week on Ballard Power ($BLDP).
Click Here to Watch
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Trader Training – The Economics of Trading
I am often asked, "How much money can you make day trading the stock market?" I understand why people ask the question but it is a question that is hard to answer because there are so many variables. It is like asking, "How much money can you make playing hockey?" For some, it is millions, for others, it only costs them money.
Of course, trading skill is the most important factor. Trading is not complicated, in fact, it is the simple things that work the best. This is not to say that trading is easy; it is actually quite hard but not because it is intellectually demanding. It is just hard for most people to disconnect themselves from their emotional attachment to money.
The rules for most of my trading strategies could be written down on the back of a napkin - they are simple. Executing them properly takes practice and emotional control. For some, that is not too hard. For others, it can be close to impossible.
You do not have to be exceptionally smart to be a good stock trader; I think most people are smart enough. It does take more determination and hard work than a lot of people are willing to invest but the great thing about both of those things is that neither is exclusive. No matter what your age, gender, looks, intelligence, nationality or social status, hard work and determination are achievable.
Before I go in to the economics of trading, let me first explain a few important concepts. The first is risk, the difference between the price you buy a stock and the stop loss point. If you buy a stock at $20 and have a stop loss at $19, you are risking $1 a share.
The reward is the difference between the entry price and the profitable exit price, assuming you are not stopped out with a loss. That stock you bought at $20 has a reward of $5 if you sell it at $25.
The reward for risk is the reward divided by the risk. In this example, the reward for risk is 5 since the profit was $5 for a risk of $1. How much you actually make depends on what your risk tolerance is.
If you are willing to lose $500 on a trade then you would have bought 500 shares in this example. $500 of risk tolerance divided by $1 of risk demands you buy 500 shares. With an exit at $25, you earn $2500 or five times your risk.
How much money did it take to make the $2500? 500 shares of a $20 stock costs you $10,000, assuming you only use your capital. If you use leverage, which most brokerages will give you at 2 to 1 and some brokers will give you at 3 to 1, you lower the capital requirement. With 2 to 1 leverage, you need $5000 to make the $2500 profit. With 3 to 1, you only need $3333. With more leverage, the percentage return goes up but so too does the potential percentage loss.
Now, what can you expect to make in terms of reward for risk? This is where there are variables outside your control that have a big effect on performance. If the market is hot, it is much easier to find winning stocks and the size of those winners will be greater than if the stock is dead. No matter how hard you work or how skilled you are as a trader, you cannot control how many opportunities the stock market is going to give you.
As a general guideline, I think that a skilled trader in a reasonable market can earn an average of 10 times risk in a week. So, if you risk $500 on each trade, you should be able to make $5000. I want to stress, however, that your skill and the state of the market are two very important variables in this calculation.
The final question is how much capital do you need to risk $500 on each trade? Again, the state of the market is an important part of this equation. There are times when the hot sector of the market is the low priced stocks. The size of your position in these stocks tends to be smaller because these stocks are more volatile. You may be able to take $500 or risk with a $5000 position (which with leverage may require less than $2000 of your capital).
In a market where the large cap stocks are the hot area you could need 10 times as much capital to achieve the same amount of risk.
As a general rule, take your risk tolerance and multiply it by 100 to get the required capital, before leverage. So, if you risk $500 you will need $50,000 of capital to take the trades that come to you. If the stocks you trade are smaller, more volatile names, that amount could be a lot less.
Above all else, none of this works if you are a person who approaches the market with a gamblers mentality. Losses are part of trading and you have to be prepared to take the small loss when the market leads you astray. When you get a winner you have to be willing to let the profit run so that the winners can pay for the losers and still leave you some overall profit.