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The importance of having the right expectations

Having the right expectations in trading will be absolutely key to your success. Many prospective traders start out with the expectations that trading is an elite method of making a boat load of money in a relatively short amount of time requiring only a small amount of funds and that when they have fully mastered it they will become multi-millionaires and have that Lamborghini and Armani suit in no time.

Now with even the most basic understanding of how derivatives trading work, it should be clear to any trader that in order to make the type of profits they are expecting, they should be trading with considerable levels of exposure.

Luckily for those looking to make big bucks, such levels of exposure are squarely in reach, even with very limited funds available to their disposal. This is due to a derivatives trading term known as gearing. This simply means that you can gear your exposure to a trading instrument with multiples of up to 300 in the case of some brokers! In effect this could easily give a trader with an account value of 10 000 access to exposure of over a million.

And with brokers usually offering demo or practice accounts with virtual account balances of up to a million, these traders have often times become accustomed to trading big with virtually no risk.

And if at this stage it isn't yet painfully clear what the problem with this is, allow me to explain.

Let's pretend I have an account balance of 10 000 and am expecting regular profits of at least 10% that. The only way to achieve such profits is to play often and play big! So if for instance I were to trade a share currently trading at a price of 100.00 and I expect a 2.5% move to 102.50, it would mean that with no gearing and only 10 000 at my disposal, my maximum exposure would be limited to 10 000 which translates to 100 shares. But with an exposure of only 100 shares, that would mean should the trade work out in my favor I would have made only 100 x 2.5 = 250 profit. And since that is only 2.5% and I am looking for at least 10% that will never do. That Lamborghini ain't going to buy itself!

Fortunately my broker provides me access to a very conservative gearing of 10 times. So since I am a big player and have access to 100 000 in exposure I can now buy 1000 shares instead of the measly 100 that my money actually affords me. This means that the same 2.5% move would have made me a much more respectable profit of 2500 translating to a proper 25% ROI. Now we are talking!

Unfortunately for Mr Big Kahuna's above, trading is a numbers game meaning it is a statistical certainty that everyone will encounter losing streaks. Now considering Mr Big Kahuna is exceptionally talented and apparently a 'natural' at trading we will be very generous and grant him an average win rate of 60%. Further considering that Mr Kahuna trades big (they do not call him Mr Big for nothing) as well as the fact that the market doesn't really care for his opinion, it is safe to assume that Mr Kahuna will likely take losses of around 20% given his lack of risk management at least 40% of the time given his respectable average win rate off 60%.

So what is the probabilities here? Since Mr Kahuna is risking on average at least 20% of his account on every trade and probably even more when he is trying to make up for lost wins it is fair to assume that he is sure to face some major draw downs. But what is the chances of consecutive losses happening when you have an average win rate of 60%?

So with a an average win rate of 60% we know that he will lose a total of 40 trades over 100 trades, but let us look at the mathematical probabilities of consecutive losses over this 100 trades period. Using an advanced probabilities calculator to help me determine the odds, let's look at the numbers:

  • There is a 100% chance that he will at least twice have 2 consecutive losses. That is two times he will lose more than 40% of his account.

  • There is a 98.8% chance of hitting 3 consecutive losses and a 92.5% chance of twice hitting 3 consecutive losses, each time cutting down his account by more than 60%.

  • There is a 80% chance of having 4 consecutive losses in a row, cutting down his account by more than 80%

  • And finally there is a very real 46.1% chance of completely wiping his account within the space of only 100 trades.

From the above it is fairly obvious that Mr Big Kahuna's expectations that trading is an easy way to leverage your funds to make big bucks is a direct cause of his lack of proper risk management. And while he might be bragging with his early winning it won't be long before he wipes out his entire trading account.

I previously discussed the importance of proper risk management and psychology in my first blog post found here:

I strongly recommend you give it a read if you haven't done so already as this is the key to your trading success.

If you are looking to find out what is realistic expectations to have when it comes to trading returns you are welcome to send me a mail or have a look at our Traders Forum under the Trading Education category.

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