Profit, risk, and professional trader expectations.
Copyright © 2016 Jose Silva
Trading career: short-term vs long-term
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ca·reer, noun:
A professional occupation undertaken for a significant period of a person's life, with opportunities for progress.
At some stage in their career, many traders may experience exceptional temporary luck and achieve a run of high profits over the *short-term*. However, experienced traders are well aware that capital-breaking drawdowns can be just around the next market turn - therefore professional traders tend to be more concerned with long-term performance. This white paper is only concerned with long-term performance expectations, over a trading period of seven years or longer.
Meaningful questions
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What are your expectations for trading success over the long-term?
To answer that, please give some additional thought to these two questions:
1) What are your personal expectations for annual net returns, over the next seven years' trading? 10%, 20%, 30%, 40% pa, more?
2) What is your worse capital loss (accumulated daily drawdowns) expected during that same period? 0%, 5%, 10%, 20%, more?
For a benchmark comparison, the S&P 500 index has averaged 4% pa returns (3/Jan/2007 - 8/Jan/2016, 9 years), with a max 58% drawdown during the financial crisis of 2008. Average traders (and most funds) struggle to match these market returns.
Expectations
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New traders often enter the markets with very high expectations for immediate trading success. Presumptions of 100% pa profits with little or no thought for interim risk (accumulated daily drawdowns) are common.
More experienced traders tend to have down-to-earth projections for longer-term returns, but often hold unrealistic expectations regarding their exposure to risk over time.
Studies show that the majority of traders lose money over time (copy & paste URL into browser):
www.travismorien.com/FAQ/trading/futradersuccess.htm
A quick Google search illustrates this issue:
www.google.com/?gws_rd=ssl#q=trader+blows+up+account
Within their first year of trading, approximately 90% of new (active) traders either stop trading or lose most of their trading capital. This persistent statistic demonstrates that a trader needs to be better than nine of his peers in the market, *just to break even* over the long term.
The law of diminishing returns
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Due to the intrinsic nature of the markets, the path to consistent profitable returns becomes exponentially more difficult from the break-even level. As human beings, we tend to think in a linear fashion; in our minds, we naturally project that doubling our efforts will also result in a doubling of profits. But the reality is that extracting profits from the market is like extracting juice from a lemon - the first half of the fruit's juice is easy to squeeze out, but the last few drops takes a lot more effort. Higher profits at psychologically-manageable risk levels become exponentially more difficult at the top end of the trading success pyramid.
Expectation formula
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To determine an approximate probability of success as a long-term professional trader, please consider this success expectancy formula developed by Jose Silva through years of observation:
Probability of success = 10 x 10^(expectant profit % pa / expectant maximum risk %)
( Top percentile = 100 / expectation formula )
Using the above expectation formula, let's look at some long-term expectations and their probabilities:
Expected Expected max Probability Trader in top
profit drawdowns of success Percentile
0% pa 10% 1 in 10 10.0%
5% pa 10% 1 in 32 3.1%
10% pa 10% 1 in 100 1.0%
20% pa 10% 1 in 1,000 0.1%
30% pa 10% 1 in 10,000 0.01%
40% pa 10% 1 in 100,000 0.001%
50% pa 10% 1 in 1 million 0.0001%
100% pa 10% 1 in 100 billion 0.000000001%
And it gets worse when risk expectations are too low:
Expected Expected max Probability Trader in top
profit drawdowns of success Percentile
5% pa 5% 1 in 100 1.0%
10% pa 5% 1 in 1,000 0.1%
20% pa 5% 1 in 100,000 0.001%
30% pa 5% 1 in 10 million 0.00001%
40% pa 5% 1 in 1 billion 0.0000001%
50% pa 5% 1 in 100 billion 0.000000001%
100% pa 5% 1 in 1 sextillion 0.0000000000000000001%
So, with more realistic risk expectations:
Expected Expected max Probability Trader in top
profit drawdowns of success Percentile
4% pa 57.7% 1 in 12 8.5% (S&P500 3/Jan/07-8/Jan/16)
5% pa 20% 1 in 18 5.6%
10% pa 20% 1 in 32 3.2%
20% pa 20% 1 in 100 1.0%
30% pa 20% 1 in 316 0.3%
40% pa 20% 1 in 1,000 0.1%
50% pa 20% 1 in 3,200 0.03%
100% pa 20% 1 in 1 million 0.0001%
Expectation formula vs the real world
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The expectation formula is probably somewhat conservative - long-term trading success is likely to be even more difficult.
Let's take John Paulson for example, generally considered one of the most successful long-term professional traders in the world. On average over the years, his Paulson's Credit Opportunities fund has returned approximately 40% pa with 25% interim drawdowns. The expectation formula 10 x 10^(40/25) rates Paulson a very conservative 1 in 400 trader (i.e., in the top 0.25% percentile of traders).
AQS-1 (www.metastocktools.com/aqs-1), the most sophisticated strategy generator in the market, often generates strategies in the 1 in 300-400 range. Based on current performance as at Jan 2016, Stralliance Capital Management's (www.stralliance.com) best-performing strategy would place it at the very top of 10,000+ traders, with even better performance expected from its new AI-based futures strategies (www.stralliance.com/soon/).
Trader success levels
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Based on the above logic, these are some typical long-term traders grouped by their performance:
1 in 2 - average trader, loses trading capital over the long term.
1 in 10 - break-even long-term trader.
1 in 12 - long-term trader who matches market returns at comparable risk.
1 in 32 - moderately successful long-term trader.
1 in 100 - considerably successful long-term trader.
1 in 400 - excellent fund manager performance.
1 in 1,000 <- outstanding long-term trader - aim for this level!
1 in 1 million - there are less than 1,000 of these traders in the world.
1 in 1 billion - (hypothetical) best long-term trader in the world.
Summary
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Successful long-term trading is a risky and daring undertaking. This is definitely not the message the financial industry wants to convey to the general public, and in any case few if any potential traders would want to hear about this reality.
High profit and/or low risk expectations are the main cause of disillusionment with trading, by both new and experienced traders.
Realistic expectations free professional traders to pursue practical profit & risk targets, leading to a more sensible path to a sustainable and successful long-term trading career.
What are your long-term profit/risk expectations now?
Given your available time, experience, access to data and tools, what is the trading success level you are aiming for?
Trade well, trade safely, and please visit this white paper again in seven years.
Copyright © 2016 Jose Silva
www.stralliance.com
www.metastocktools.com/aqs-1