Saturday, July 04, 2009

What Are Reasonable Performance Expectations For Traders?

How do I know if I'm doing well--or poorly--as a trader? That is the topic of an insightful question from a reader:
The question that no one has answered to my satisfaction goes to the
heart of managing my expectations. It is very hard to know how well
you're doing, or what you're doing wrong, when you don't have a
standard by which to judge your performance. For instance, a trader
once told me that a good day trader should make money every week,
not every day, but every week. Somehow I doubt that such level of
consistency can be reached. But this has caused massive confusion
on my part. Without knowing what elite traders go through, it's hard
to judge whether I am doing something wrong, or whether I merely
lack patience to stick out through inevitable drawdowns.

So my question is...where can I find information of elite day traders,
in terms of their performance? Mentors are notorious for not
opening their books, so the only people I talk to are aspiring traders
such as myself. The answer to this question will at least give me a
standard by which to judge my performance. For instance if I know
that it's normal for a top daytrader to have a losing run of 'say'
two-three weeks, then I won't 'panic' as much if I've lost money
three straight days.

I address issues of performance--and reasonable expectations for a trader's learning curve--in the Enhancing Trader Performance book. That book is useful in that it tracks the phases of the learning process and what one needs to do to move from being a novice to being competent to becoming expert. Chapter Eight of The Daily Trading Coach also suggests specific metrics for evaluating performance and guiding self-coaching. This is important, because it addresses, not only whether you're trading well, but also whether you're getting better over time.

At the firms where I work, trader P/L is audited daily and is a matter of record. I can see verified statements of how traders perform. This is useful because, as the writer points out, false portrayals abound. Many are faking it, hoping that they'll eventually make it. One guru who offered his services made the claim that he made over a million dollars from trading every year for the past ten years. That sounded pretty impressive--until I learned that he was only toting up the wins from his day trades. Yes, he made more than a million dollars' worth of winning trades. What he didn't say is that he also made more than a million dollars' worth of losing trades! Deception abounds--

Of the traders I've known personally through my work, only one rarely has a losing week. He is quite disciplined in his trading and limits his trades, both in size and setups. That prevents him from losing too much on any one trade, and it keeps odds in his favor. Of the hundreds of other traders I've known well, every one has had losing weeks and strings of losing weeks. Indeed, it's not uncommon for excellent traders to have losing months or a period of losing months. Markets change, slumps occur. If you are profitable on 70% of your weeks, 2.7% of the time--or about once a year--you'll have a string of three losing weeks simply by chance.

It's great to make winning weeks your *goal*. And it's good practice to never lose so much money in one day that you can't have a green week. But there are plenty of elite traders who make good money and undergo losing periods. I work with them every week.

So what *is* a reasonable expectation? Calculate your returns on an unleveraged basis. If you're making twice the riskless rate of return after commission costs, you're doing very, very well. If the riskless rate of return is 3.5% on a 10-year Treasury note, then a 7% return, unlevered after costs, means that you (or a trading firm) could leverage that trading (assuming scalability of trading strategy) into attractive double digit returns that would reward the firm (and firm's investors) as well as the trader.

By calculating your return after costs and on an unleveraged basis, you focus yourself on realistic, risk-adjusted returns. Retail commissions make achieving such returns challenging. If I have a $100,000 portfolio and trade a 2-lot of ES once a day at $5.00/round turn, I'll rack up $2500 of commission costs over the year. That's 2.5% that I have to make simply to break even on the year with infrequent day trading! For a frequent trader, the commissions are so high at the retail level that sustained success becomes prohibitively difficult.

If you have a genuine edge, you should make a respectable return without leverage. That can turn into a superior return simply through the judicious use of leverage. But if you can't sustain an edge without leverage, leverage will magnify your trading flaws and invite risk of ruin. In my view, you're a competent trader if you can consistently cover your costs without resorting to leverage. You're a superior trader if you can sustain more than the riskless rate of return after costs without leveraging your capital.

For more on this topic, check out my post on trading metrics (and its links) and this one (and its links) on keeping score in your trading.