Sunday, January 10, 2010

Mama, Don't Let Your Children Grow Up to be Traders

Someone recently asked me a great question: "Would you encourage your children to pursue trading as a living?"

My answer was immediate: "No, I wouldn't encourage it. If they wanted to try and showed some aptitude for it, I wouldn't stop them, but I would never push the idea. The odds of sustained success are simply stacked too high against most traders."

To me, the question was no different from asking, "Would you encourage your children to go to Hollywood and pursue movie acting?" I wouldn't stop a child that had shown acting talent and that had the drive to succeed, but I would never encourage a kid to spend time and money simply to give a fantasy a shot.

But therein lies a world of difference: You would never send your child to L.A. to pursue an acting career if the child had never so much as starred in a high school play. Still, young traders pursue trading without truly understanding how markets work and without observing and trading markets on their own. Theirs is a fantasy, not a career plan.

The odds truly are skewed against an individual trader's success, just as the odds are skewed against gamblers in Las Vegas. I recently talked to the head of a professional trading firm, which is a member of several exchanges. Because of the institutional status, traders at that firm pay far less than $1.00 per round turn to trade the ES contract.

An individual trader would be lucky to get a $4.00 rate.

So let's take a 20-lot trader at the pro firm; that corresponds roughly to $1,000,000 of buying power. That trader trades ten times a day, transacting 200 round turns. At the $1.00 rate, the trader spends $200/day or about $50,000 per year in commissions. That's a 5% return on capital that is stripped from gross earnings.

Now let's take the individual trader trading the same way, same size. The commission is now $200,000 or 20% of capital. The trader could have a significant objective edge in the market and real skill and never see a penny of net return.

And that's before considering other fees and expenses that enter into trading.

Unless a trader has a true institutional advantage, great training, and a real edge in the markets, the casino's edge will eventually erode all of his or her capital.

Why do you think most trading software products and brokerage house innovations are geared toward making it *easier* to find and execute trades? It's in the casino's interest for you to trade more. The oxygen pumped into the real casinos? The free drinks on the gambling floors? The flashing lights and loud sounds? Keep 'em awake, and keep 'em loose: the house take is greatest if people are gambling.

Don't get me wrong: I see success stories in trading every day, and I see people making millions of dollars per year. But they don't start with small bankrolls, they don't pay commissions that give the house a huge edge, and they don't trade with such shoddy platforms that they give up another edge by getting inferior prices on their buys and sells.

So would I emotionally and financially back my kid if he or she wanted to pursue trading for a living? Like any venture capitalist, I'd look for a solid plan, not a half-baked fantasy. You can't sustain a living if your overhead exceeds any reasonable expectation of return, and you can't sustain a new business if you're undercapitalized.