Trading is tricky

Trading

Brokers visit us to pitch that they will be able to generate regular income for us by trading. I understand that this is one of the most common pitches made to clients by some brokers.

A recent article gave some interesting insights into equities market. It stated that 50%-60% of the equities belong to “controlling stake holders” and there is almost no trading by this segment. 5% to 10% of the equities are held for over 1 year period, hence there is limited trading. 30% to 45% of the shares are held for less than a year and represent bulk of the trading volumes in the market. Trading seems to be a very popular profession/sport.

To evaluate brokers “trading pitch” we have a few questions where we try and get some quantitative information. Most responses we have heard so far were qualitative. We try and persist till we get some quantitative answers, usually they offer to “revert” with the data requested, which has not happened so far. Here are the 5 questions we ask and a summary of the responses received so far:

  1. How of then do they trade?
    1. Typical response is “not that often”. This tells us very little so we try and find out if how many times they trade in a year, we usually end up with some vague answer, which also includes “it depends on the year” etc.
  2. What gives them the edge?
    1. Very rarely do we hear a convincing answer about why their research or process gives them an edge. Some talk about “their right connections” – potentially hinting at “better” information.
  3. What percentage of trading calls are right?
    1. Answer is “usually most”. When we persist about the percentage of success, most don’t have much data, at least that they can share.
  4. What is the average gain or loss in each transaction?
    1. Most don’t have an answer for the average numbers. They are happy to share some of the best trades. But somehow there is a significant difficulty recalling the large losses.
  5. What are the post-tax profits for their clients in the past couples of year?
    1. This question baffles most brokers, seems like very few ask about the post-tax profits at all. The way we see it, if we are making profits we should be concerned about taxes, as short term capital gains are taxable. And if we are not going to make profits, we there is no point in having a conversation in the first place.

Some of the baffling answers we heard were that more than 2/3 of their calls are right but they trade very selectively.  Next part of the article will give reasons for our bafflement.

We created a framework to analyze the chances of success of a trading proposal. We want be ready in case we encounter someone with a really good process/record.

Our framework is a monte carlo simulation for 1000 iterations for various cases. In this blog we are presenting a generic analysis. We assumed that brokerage & taxes (STT) both at 0.1% of the transaction value. We assumed that each trade can have maximum profit of up to 10% and maximum loss of up to 5%. We randomly assigned a profit/loss of -5% to 10% to each trade. We assumed that the entire capital is deployed for each transaction. Here is the summary:

Monte carlo simulation for trading

Based on our analysis –

A person who is getting 55% of the calls right and is trading on monthly basis

  • On an average loses 20.7% of the capital
  • Has a chance of making 10.8% profit in a good year

A person who is getting 55% of the calls right and is day trading

  • On an average loses 98% of the capital
  • Has a chance of losing 93% of the capital in a good year!!!

People who are right 55% of the time should trade as little as possible.

A person who is getting 2/3 of the calls right and is trading on a monthly basis

  • Will break even on an average
  • Has a chance of making 46.5% profits in a good year

A person who is gets 2/3 of the calls right – and is a day trader

  • Loses 13.4% of the capital on an average
  • Has a chance of making 371% return in a good year.

People who are right 2/3 of the time or less should trade as little as possible.

A person who is getting 70% of the calls right and is trading on a monthly basis

  • On an average makes 9% profit
  • Has a chance of making 58.5% profits in a good year.

A person who gets 70% of the calls right and is a day trader

  • Makes 382% profit on an average
  • Has a chance of making 2523% return in a good year.

People who are right more than 2/3 of the time should trade as much as possible.  If they trade once a month then their average profit is very close to fixed income return.

We were surprised because brokers who said that they were right more than 2/3rd of the time were also saying that they trade infrequently. Whereas an ideal strategy for them will be to trade as often as possible without hurting their odds of being right.

Let’s look at the fundamentals:  Traders have a tricky job because

  • They have to get the direction right (that the stock will go up or down) – this is possible with good analysis
  • They also have to get the timing right – this is very difficult. Even if the call is right, markets can be irrational for longer periods than people can hold a position. Traders usually have to close their positions as they have limited time frame.
  • The more decisions a trader takes the greater is their chance of going wrong.

Based on our analysis, traders will consistently make money only if they are right more than 2/3rd of the time. If they are able to get more than 2/3rd of the calls right then they should trade as often as they can to generate interesting returns. But the lacunae is that, increasing trading frequency has a high chance of reducing the odds of being right.

Is it possible to make money by trading?

Yes it is, but one should have a consistent great edge. For instance – Jim Simons (renaissance technologies), did this successfully and became a billionaire. Jim is a brilliant mathematician and has a team of PhD’s for Harvard and MIT working with him – they have extremely sophisticated models to gain an edge in the market.

Trading generates revenue for the broker. Broker makes money (commission) even when the client loses money. Brokers have an incentive to promote active trading – but that does not mean that it is good for the client.

People without a significant and reliable edge will be best served if they don’t venture into trading.

For those who are evaluating trading – 5 questions listed above would be a useful starting point. We are also attaching our simulation spreadsheet – we have parameterized it to a certain extent. You can use this to run your own simulations before you make a decision to take up trading.

 

Happy investing … err.. happy trading…

 


 IndusWealth:Making your money work for you

About Praveen Reddy

http://in.linkedin.com/in/praveenreddyinduswealth

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