Saturday, August 01, 2009

The Challenging Economics of Trading for a Living

A reader sent in this heartfelt personal story as a comment to an earlier blog post. I thought I would post it separately as a possible learning experience for those who aspire to trade for their livings:

This is the one advice I would have for anyone wanting to start trading for a living:

Open a new checking account (or empty your current account) and trade for a month. After each successful trade, send half of the gains to the checking account. The other half stays in your trading account to compensate for losses and increase your capital.

After a month, start paying all your bills from the new checking account. Keep doing this for several month and be totally honest. And see where that takes you.

This is the best wake up call I can think of.

I started trading for a living 8 years ago, because there was nothing else I could think of that I could do to make a living.

At the age of almost 50, I found myself alone. I had never worked. Had no education and had a physical handicap that prevents me from doing much manual work. All I had was a tiny savings account.

I looked into what I could do with it, and became very interested in economics and how the financial markets work. Actual trading was the part I liked least, the research, the part I liked best.

For the first 5 years, I doubled my account 4 times. I believed I was becoming a good trader. I was, but what really helped was that I was in the right sectors at the right time. The charts of my trades show many mistakes, but I was riding a bull, and making money.

At the same time, I was staying with a friend, and my expenses were at a minimum, so my account grew.

Four years ago, I had made enough to buy a small house for cash and still have a trading capital. Now I started having more normal expenses. I have always been a very frugal person and live on well below average expenses. And yet, my gains never completely covered my expenses.

I didn't follow my advice, because I never thought of it then. I paid my expenses from my capital rather than my gains. For the past 3 years, my capital has been reduced to almost nothing.

Today, I face a very uncertain future, if any future at all.

You might think I must be pretty mediocre as a trader. My expectancy is 1.46. For every dollar at risk I make an average of $0.46 gain. Or an annual average of 46%. Not bad. But the gains were never enough to pay the bills, and my capital melted away, a little at a time, every month.

I hope someone can learn something from this.

Now we can quibble about details of the writer's account; I'm not sure taking money out of one's account after each successful trade is the way to go, for example. The writer's broader point, however, is very well taken:

If you're going to trade for a living, you need to tightly control your overhead. You cannot assume that past, high returns will continue indefinitely into the future. You need to harvest money in the good times to ride out lean periods. You need to protect your base capital in case profits are wiped out. You cannot win the game if you cannot stay in the game.

What happens with too many traders is that they begin with aspirations that do not match their account sizes. They want to trade for a living, but their base capital will not support their goals if returns are anything less than consistently stellar. When good returns are achieved, those traders keep all their earnings as risk capital to build their account size. When the inevitable slumps hit, they take a decent percentage drawdown from a larger capital base. That can leave them worse off than when they began.

For instance, take a simple example: If I start with a capital base of $100,000 and make 50% in a year, keep profits as trading capital, and then have a 50% losing year, I'll finish my second year of trading with $75,000--down 25%!

A business owner cannot sell off parts of her restaurant to pay the bills--at least not for long. A baseball team owner cannot sell off one player after another in order to keep the team afloat. A solid business plan details how the business will be self-sustaining: how profits will support the ongoing maintenance and growth of the firm.

Trading for a living is much harder than people assume: profits after expenses must be sufficient not only for you to live off of, but also to grow your account. Little wonder that so many businesses begin with investor loans; that so many traders begin by trading the capital of others. It is difficult for any business to start up with enough capital to both support the founders *and* fund the firm's growth.

This is the "afflicting the comfortable" part of the blog. Few gurus, educators, and mentors will emphasize the financial challenges associated with making trading a living and even fewer will linger to tell the stories of those who have fallen short in their efforts. It is wonderful to lift your eyes to the stars, but always make sure your feet remain firmly planted on ground. Failing to generate and follow a workable business plan too often amounts to planning to fail.

For more on this topic, see the post on performance expectations for traders.