Saturday, February 03, 2007

How Large An Edge Do You Need to Succeed at Daytrading?

In past posts, I have tried to capture what separates market pros from the less successful traders. I've also stressed the importance of tracking the market pros in short-term trading. There are many factors that contribute to trading success. Some of those are psychological; others relate to skills and talents and how those match up with the markets we trade. This means that, to become a trading professional ourselves, we inevitably wind up working on both ourselves and on the markets we trade.

But how much of an edge does a professional trader need for success? Allow me to relate an incident from this past week that nicely illustrates an answer to this question.

Not infrequently, traders will write to me and share their trading ideas and methods. Over the years, I've learned quite a bit from these interactions; they've been personally rewarding and often helpful to my trading. This past week, a gentleman who had been following my morning market comments on the blog shared his trading methods with me, indicating that he thought they would aid my timing. My initial impression of his methods were that they were sound. While I cannot share the specifics of his approach, suffice it to say that it can be described as a short-term trend following methodology with unique ways of defining both entries and price targets.

He shared with me specific examples of his setups and I could see that his trading was highly structured. I mentioned to him that he might want to actually backtest his ideas and integrate them into a formal trading system. Toward that end, I referred him to someone I consider to be a wizard at developing and testing trading ideas: Henry Carstens. Mr. Carstens is a successful trader in his own right and has many years of experience testing out systems in different time frames and markets. He is also a professional of consummate integrity and would never rip off people's ideas or develop a curve-fit system and pawn it off as a viable trading strategy.

Literally within hours, Henry coded the trading ideas and tested them over the past five years of market data. The system was profitable every single year. Incredibly, close to 80% of the trades were profitable--and that was with no optimization whatsoever. But what was the edge? Henry reported that, after slippage and commission were properly factored in, the system had an edge of one tick.

That's it.

The trader who corresponded with me was a bit disappointed. That doesn't sound like much of an edge, he said. Henry and I begged to differ. Here's why.

An intraday trading strategy generates a fair amount of overhead in commissions and slippage. If you wind up buying the market's offer price and selling the bid, you lose a tick right there. At a retail commission of, say, five dollars per contract per round turn, you generate annual commissions of roughly $1250 per contract just trading once per day.

Let's say, for argument sake, that you have a $100,000 portfolio and that you'll trade 10 lots once per day in the ES futures. If you lose a tick per trade on execution/slippage, you'll be down ($12.50 * 10 contracts * 5 days per week * 50 weeks per year) = $31,250 per year. At the aforementioned commission rate, you'll be down $12,500 per year. So right off the bat, you're in the hole by over 40% of your initial portfolio value. And that is *before* we consider other trading overhead, such as expenses for computers, software, online connections, redundant systems, etc.

Given this reality, you can see why my definition of a competent trader is one who is consistently able to cover his or her costs. To cover one's trading overhead actually requires a high degree of profitability, and most traders can't do that.

[Please note how rarely the trading industry acknowledges this basic economic reality and ask yourself why.]

So when Henry said to our trader that his system averaged a tick of profit after slippage and commissions, he was saying that--without any tweaking whatsoever--your ideas are more than competent. Indeed, if we use the example of the $100,000 portfolio that trades 10 lots in the ES market, that system would return $31,250 per year, or about 30% annually. On a year in and year out basis, the world's best hedge fund managers would be proud of such a return on capital.

But now suppose that our trader decides to ramp up his trading and access the greater size and lower commissions afforded by a proprietary trading firm. With round-turn commissions per contract of well under half a dollar, it suddenly becomes feasible to trade hundreds of contracts per position. Even with the fees and 50/50 profit split that is common at many prop firms, our trader with a one tick edge trading 200 contracts per position will have a very respectable six-figure annual income.

And if you consider a manager at a hedge fund handling a portfolio worth $500 million, you can just imagine the returns that a single tick of net profit per transaction would bring. It's not the size of the edge, but the frequency with which the edge can be exploited--and the size with which it can be exploited--that makes the trader a living. Most of the pros that I've personally known and worked with *don't* have a huge edge in absolute terms. But they have an edge that they can exploit frequently and with size.

I hope this helps to explain why undercapitalization is probably the greatest barrier to success in trading. If, say, our trader begins with a portfolio of $20,000 and trades two lots rather than tens, that same sound trading methodology would yield profits of a little over $6000 a year. That's actually a very respectable performance in percentile terms, but it will hardly make anyone a living.

To hope to make a living from a $20,000 portfolio, the trader in our example either has to have a huge edge after all costs or has to trade with maximum leverage and frequency to exploit a smaller edge. That is simply asking too much of any trader. No one sustains that kind of edge with regularity year after year--not even the top portfolio managers--and no one ultimately can survive the lack of risk management that results from trading maximum size with maximum frequency.

When traders are undercapitalized, they have to swing for the fences, and that's generally what kills them. As with most businesses, you need a certain amount of capital to invest in your trading to make a living from it. Even our trader with a $100,000 portfolio is not going to sustain a family on the income from a very sound trading methodology.

So what kind of an edge do you need to succeed at daytrading? Like a gambling casino, you don't need a large edge. You just need to replicate that edge with enough money and enough frequency to add up. That requires sound trading ideas and a sound capacity for executing them. In my next post, I will outline several features of the trader's successful system that should be part of every trading pro's playbook, whether they trade mechanical systems or discretionary ideas.

My thanks to the trader who corresponded with me and to Henry Carstens for contributing to the ideas in these posts.