A common query that is in every new trader’s mind before he even thinks of opening a trading account is how much can I realistically make in the first year of trading stocks and options. It’s a legitimate question and one that is asked before starting every venture. However, the answer, when it comes to trading is not as simple as it is with any other business.
This is because trading deals with uncertainty at every step, unlike other businesses. In a manufacturing business, if there is a customer who agrees to buy a fixed quantity of material every month, there is some certainty of sales. But when it comes to trading we are not even certain if the next trade is profitable or not.
Trading, as they say, is the art of dealing with uncertainty. It has more to do with emotional make-up rather than complex strategies. The best traders in the world use simple strategies but follow it consistently irrespective of the series of losses.
It’s the uncertainty that makes future earnings projection difficult, if not impossible. But since the question is a legitimate one and has to be answered before venturing in the business, we shall look at how to arrive at some reasonable figure to see through the fog of uncertainty.
But before considering how much one can earn in the first year of trading, one needs to estimate where one stands in terms of learning.
Trading Education: Just like a doctor who has recently acquired his degree is expected to undergo internship under a senior doctor, a novice trader needs to first educate himself and then undergo practice ideally under a trader or he should first paper trade (logging trades as if they were real trades). Jumping into trading without a proper education and relying on tips has a short shelf life for the trader. If one plans to start trading based on another person call we can be certain that he might in all probability end up with a smaller account than he started. Just like the doctor or any professional has to have inherent skills, so does a trader. His self-confidence on his trading skill defines how much he is going to make.
Business Plan: As mentioned earlier, trading is like any other type of business, thus as an entrepreneur would first prepare a business plan to ascertain the cost and other inputs needed to start the venture, a trader needs to put all the resources needed, monetarily as well as in terms of systems, people, broker, knowledge, and strategy.
Strategy: After the initial education of trading of either technical analysis or algorithmic trading or any other form of trading, the next thing needed and one that will decide the failure or success of the traders is a robust strategy. As a beginner one can start with simple strategy and then make modifications on it. Every aspect of the strategy needs to be clearly defined. The entry signal, entry level, exit levels and more importantly the stop losses. Before using the strategy the trader will have to back-test his strategy to get an idea of how it worked in the past. A strategy which gives a higher number of losses than profits can be turned profitable by proper money management systems. Many trends following strategies have a less than 50 percent of their trades as profitable. But their quantum of profits far outweighs the small losses which makes them successful.
Money management: One of the least understood and most important aspects of trading is money management. A novice trader generally does not understand the importance of money management till he is halfway through his learning curve. As mentioned earlier a strong money management system can make even a strategy with a poor risk-reward ratio profitable. The amount one needs to invest in each trade, the risk capital for each trade and when to increase the size of the trade all needs to be covered under money management. It is advisable to bet only 1 percent of the corpus in each trade. Many traders advise their interns to start with 0.5 percent risk.
Extrapolation: With the historical performance of the strategy during back-testing and the results of paper trading will a trader be able to get an idea of how much he can make in a year. If the study of his strategy shows that it can be profitable 55 percent of the time and his average win trades are twice as large as his average loss trade it then becomes easier for the trader to calculate his performance. Say, for example in a year if a trader takes 100 trades and has risked Rs 1,000 on every trade. Going by the historic calculation 55 trades are winning trades and the trader makes an average of Rs 2000 for a winning trade and losses Rs 1000 for a loss trade. Thus by the end of the first year, he will earn Rs 65,000 on a risk capital of Rs 100,000.
Stocks and options: The above discussion, especially the money management and extrapolation part is largely applicable to stocks and futures. But when it comes to options the game is slightly different. This is because the forces acting on the price of an option are apart from the price of the stock. The interest rate, time and volatility all play an active role if not a more important role on the price of the option. Extrapolating a performance of option trader can again be done in a similar manner as in cash, but each strategy has to be tested separately on each stock and that too for every month. In some months the stock might have a lower volatility than others, so the trader might prefer to buy an option contract rather than sell one when volatility is high. Yet the exercise of back-testing can result in some tentative ballpark figure on the possibility of earning in future.
Also Read: How to make money in Indian Stock Market
While one would like to know how much one can enter before entering trading, the uncertainties and changes in the strategy will result in the final number being completely different than what was envisaged. Yet, as is human nature one would like to know the end even before starting the journey.