Measuring Trading Performance (Part 1)
It never ceases to amaze me how most traders measure their success only by focusing on how much money they made in XYZ stock or how they predicted ABC stock to go up and it doubled since then. Well, what else could there be, after all isn’t it all about return on investment?Actually… No. Doesn’t anyone ever wonder at what risk were those returns made? The concept of risk management is not new, it has been around ever since markets have been established, and certainly is part of every other established industry, whether it’s manufacturing, insurance, healthcare or fund management. So then how come we do not hear much about risk management in trading circles? It is because to most amateur traders overlook risk management until they actually feel its absence during a market downturn. Risk management is like insurance, by the time you realize you need it, it is too late. Lack of adequate risk management has been blamed for trading scandals at NAB’s Forex department and the collapse of Barings Bank. For long established traders, a large part of their trading plan consists of risk management in fact most of the trading “wizards” interviewed in Jack Schwager’s book “The New Market Wizards” confirm: 80% of trading success comes from Managing Risk. Even Donald Trump, who was referring to business conduct in general said: “Manage the downside, the upside will take care of itself”. If established entrepreneurs and traders believe they cannot be successful without solid risk management, wouldn’t it be prudent for us to take a closer look at what they are talking about? So what is risk management? “Risk management is about using trading rules to limit losses” (Alan Hull).
For traders and investors there are a number of obvious risks they may come across during trading, including:
1. Market risk,
2. Inflation risk,
3. Principal risk,
4. Liquidity risk,
5. Credit risk.
In this article I will be focusing on market risk – the possibility of loss due to adverse direction of the share price. To demonstrate the effects of risk management or lack of it on trading performance can best done with an example. Let’s say there are two traders, Bob and Joanne. Bob enters his trade on RIO at $30.00 and buys a quantity of 1,000 with an initial exposure of $30,000. This trade entry is depicted below using TradeRisk trade manager:
After some time, RIO goes up to about $58.00 and Bob calculates his return on investment to be about 93%. He is pretty happy about this as he almost doubled his money with very little effort. Bob does not believe in stop losses as he is pretty sure this stock will only go up since it is a “solid blue chip company with great track record”. So he puts the initial stop at a small value, just so that he can enter the trade, believing it will never get that far low.
Joanne enters the same RIO trade at the same time for the same price at $30 and a quantity of 1,000. At this point most of us would think Bob and Joanne have the same trading performance since they both entered at the same time and now enjoying a 93% windfall.However at the time of trade entry, Joanne decided to put in an initial stop loss at $25. As the price of RIO increased, she kept placing trailing stops to ensure she would not lose more than about $5.00-8.00 per share on this trade. Now that RIO is trading at $58.00 her trailing stop is at $50.00. Joanne’s trade entry details are depicted below.
Now let’s compare their trading results:
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The following points worth noticing:
- Joanne has made just as much money as Bob, $28,260.00 just by the price of their investment going up from $30.00 to over $58.00. This results in 94.20% return on investments;
- Their exposure in this trade is the same - $58,260;
- Joanne's stop loss is at $50.00 meaning that her trade will only need to drop 14.18% (How far is S/L column) before she exits the trade. Since her return is well over this (94.20%) - she cannot lose on this trade. In fact once her stop loss goes up to $30.00 her worst position is a breakeven, as shown on the picture below:
- Bob's trade is well and truly exposed to whatever happens to the price of RIO. He is essentially risking all his winnings and original investment on this trade. This is clearly depicted below:
- Joanne's profit/risk ratio is a lot higher than Bob's (5.65 vs. 0.97 respectively). This ratio, shown as "R" on the pictures above and it compares their profit to date to the initial risk established during the trade entry. The initial risk put up by each trader is calculated automatically by TradeRisk, using the trade entry price, initial stop loss and purchased quantity. Since Bob decided to have a very small initial stop loss value, he is risking his entire investment whereas Joanne only risks a fraction of her total sum invested.
- Since Joanne takes her trading seriously and always is on the lookout for ways to improve her performance, she reviews her trade's key performance indicators and their historical daily performance. Even though she is comfortable with her trading rules, she conducts regular reviews of trade daily performance to see any room for improvement. After all wouldn't any of us want to know if our favorite trade that has made say 50% return on investment actually was up over say 80% a few weeks ago?
As you can see the net return is not everything when it comes to calculating trading performance. I trust the above example has demonstrated the importance of managing the downside of any trade regardless how well the stock (or whatever instrument) has been trending.
As a final scenario, imagine over the next few weeks RIO reverts to $55.00, then $50.00 and than $45.00 Joanne’s stop loss is hit at $50, locking in her profits and watching as RIO slips past the $40.00 mark whilst Bob is confused and left hoping that the share price comes back.
To assist Bob in making better trading decisions in the future, I have listed a few “solid blue chip companies with great track record” with share price % fall between Jan 2001 and June 2002:
- Enron - 99.9% (This company was once considered the World's largest energy company)
- Global Crossing - 99.7%
- ImClose - 79.4%
- Tyco International - 78.4%
- Dynergy - 88.9%
- Qwest Communications - 95.6%
- WorldCom - 93.8%
Arpad Marton – HiQTraders.com Read more articles from the Stock Investor Journal. Get data to assist you in managing your risk.