By, Dale Brethauer
In part III of this course we’re going to continue on with Developing Your Trading Business Plan. We have discussed a number of very important elements – your goals, your affirmation, your trading strategy, your money management – and now what we're going to be talking about is developing realistic goals, and how can you see whether or not a rock solid strategy will give you those goals. We're going to be looking at a learning curve, and we're going to be looking at a potential setup for a portfolio as your portfolio gets bigger.
This topic was first presented at Traders Expo in Las Vegas in November of 2009. I have to admit, the positive feedback that I received and the continual emails about people that have used this successfully and helped them to develop their trading as a business and to become a success. I'm wishing the same thing for all of my people that are listening right now.
We've looked at what happens with losing traders: no goals, exposed to too much risk with no rules and no strategy. In the final lesson, the focus will be on reigning in unrealistic expectations. Retail investors are commonly under-capitalized, and they expect to make a killing. The market loves the chum of habitual gamblers and makes millions exploiting this addiction like behavior. But, if you have realistic expectations and enter each trade diligently, you will be successful. With the right strategy, rules, and expectations any account can reach six or seven figures on a long enough timeline. Let’s continue.
Part I was the developing the goals and affirmations. Part II was developing trading strategies, rules, and the potential trade size to keep your money management in check. Part III, we're going to be talking about expectations, portfolio structure, and the learning curve. In Part II, we looked at the trading size based on a $30,000 portfolio. One of the things, if you're trading credit spreads, you might look at about $10,000 margin, and that's about 10 contracts. Giving the guidelines that we've established for SPX trading when you're just trading an option contract, you might go ahead and choose to trade a thousand dollars per trade. That's well within your trade size for that $30,000 portfolio size, and that's about four contracts. The trade size will focus you into how much you can afford to put on each trade and continue to be profitable. Even though you're going to have losers, and you're going to have losing streaks, a proper trade size will keep you in business.
We’re going to be talking about expectations; we're going to be talking about potential portfolio structure; and we're going to finish up with learning curves. Part III is going to have those three elements. Remember, let's look at all the elements we need for a trading business plan, and allow it to be an evergreen document. I change my plan on a regular basis. I think it's great to look at this and say, okay, have I accomplished this? Have I done this? Do I need to change anything? It's a wonderful plan to keep you focused and keep you focused on your potential profit and your success.
Expected Returns Per Trade | Model
The middle formula was taught to me by Dr. Van Tharp. It's a formula to estimate your expected returns per trade based on a given strategy. Now, the strategy that I was using here is credit spreads. These are credit spreads I actually made so far this year in 2017. Let's assume an account size of about $30,000, and let's put on $10,000 margin. Now remember, that's only the amount that the brokers are going to require. That's the max you could lose; we're never going to lose that amount. The max we're going to lose is about 6% of that, which is about $600. We're well within the trade size when we go ahead and put that on for credit spreads.
Options Infinity Results & Typical Expectations
So far this year I've executed about 18 spreads. That's going to give me about 27 trades annualized. The formula is, you take the profitable percent of being right times when you are right, what percent do you make, minus your losing percent times when you lose, what have you risked. Then what was your P&L times the trade size. So far this year the credit spreads have been very, very profitable. It's been running about 84% wins, which is really unheard of. (Okay, I hate to toot my horn, but I'm going to. There's nowhere else that you're going to find that has that kind of a win percent.) You might not do credit spreads. You might have some other strategy. It's whatever your strategy is and what percent is right. What percent are winners? What percent are losers? The more trades that you have, the more correct this expected return equation will be. Statistically, probably you need at least 20, if not 100 trades, for this to be something that you can pretty much bank on.
Breaking Down your Growth Model
This year's been 84% correct, 16% losers. When it is correct, we're making about 10 ½%. When we're losing, we cut it to about 6 ½%, times the margin. Every time we make a credit spread, we know we're going to make $800 even before we do it, because the rules say we're going to cut it with a profit of about 10%, and we're going to cut it with a loss at about 6%. Yeah, the percent win and loss might change a little bit, and you can play around with this equation and plug in different numbers and see what it comes out to be, but then if you look at the expected return per year, you take that $800 per trade times the 27 trades, and you're coming up with a whopping $21,600 on a $30,000 account.
Now remember, past performances are no guarantee of future results. This has been an exceptional year. Would I look forward and say this is what I can expect year, after year, after year? Like I said, the more information you have, the more accurate this becomes. This is now what you call a positive expectation trading strategy, and that's what you want. Your job now is to learn the rules, stick to the rules, execute the trades, not let your ego get involved, and to just sit back, and relax, and go through the losers and the losing streaks, and just continue to do what you're doing, and you will ultimately become a success.
Building a Typical Expectation Model
Here’s some realistic expectations using weekly options, specifically based on the SPX. Here, the trade size is about $1,000 based on an account of $30,000. We estimate we'll have about 60 trades within a year, a little bit more than one trade a week. Of course, we went over the expected return per trade, which is an awesome formula to determine whether or not you have a positive expectation trade. Here, we had a lower percent, about 50%, 50% losers.
The thing is, when we had winners we made more money than when we had losers. Take that times the trade size, we came up with a positive expectation every time we make a trade, based on this trade size and this account size, times what we have for the year, and that gives you the expected yearly return based on this account size, about 33%. That's also unheard of. A lot of the larger hedge fund managers would kill for this kind of result.
The majority of my portfolio is in stock, and only a small portion is in these two strategies. If you're just starting out and you choose to use one of these strategies because you've got a smaller portfolio, it's going to serve you well.
Capital Allocation Based on Expectations
Most of my portfolio is in stock and some ETFs and some indices, and you'll notice I say stock with protection. I have about 80% of my portfolio in stock, and when it goes against me, sometimes I will buy what's called a protective put. A protective put, you take the number of shares that you have and you buy the same amount of contracts of puts, so that if it goes down, the put will go up in value and protect you from a loss. I also use the same tools for stock trading as I use for anything else, and the two biggies are regression channel and the Fibonacci’s. I've been using these for many years. They are the absolute best as far as telling you when to get in and when to exit a trade.
Portfolio Allocation: Modified Buffet Rule
As a rule of thumb, I've got about 80% in stock, about 10% in SPX options, and about 10% in credit spreads. If you look at this and you base it on a half a million dollar portfolio, I'm looking at about $400,000 in stock, $50,000 in the SPX and $50,000 in credit spreads. Doesn't that make sense? Stocks are my slow-growers, and I'm okay with that because I've got the biggest magnitude there. I don't need that big return on investment; I need, really, about 15% a year on a consistent basis, that's fantastic whereas down here, I'm looking for a little higher return, but I've got less money involved. My trading is relatively low-anxiety. I sleep well at night because I know that I'm not over-trading, that in the long run this balance is going to work for me if I continue to follow the strategies and follow the rules.
Set your Path and Follow It
The last thing is the learning curve. When we first started out we talked about the goal. The goal was that we had a $30,000 portfolio and we wanted to make $1,500 per month. Okay, even before I get started, what I want to do is back-test my strategy, whatever the strategy is you're going to use. Like I said, you don't have to use what I'm doing; there's a myriad of systems and strategies out there. Find one that you like. Are you a day trader? Are you someone that doesn't like to trade very often? Are you risk-averse, or can you take a little bit more risk? Develop your own business plan and back-test it. Then test it on paper; run through your expectations; see if you have a positive expectation.
If you're losing with paper, don't go into real money. If you can't make it on paper, how do you expect to make it on real money? Make sure that your strategy has been tested and that you're making money on paper before you ever commit any of your hard-earned money towards this. The stock market is extremely difficult to consistently make money. However, if you put the time and effort and have realistic goals, it can be obtainable and it can be something that you can use for years and years.
So, we've got a start point, and here's my end point. Remember earlier we said that our goal was in ten years? In ten years, we want to be making $5,000 per month because this is the amount of money that would help me with my financial freedom. This is the amount of portfolio that I need, so I need a learning curve that will take me up to that goal. Now, I might be going up the learning curve and all of a sudden I have some draw-down. I need to stop and I need to look hard at what happened there. Do I need to change my rules? Do I need to change anything? Do I need to go back to paper? Then, you get back in and let's say it goes up. If you work diligently on this business, especially if you follow the business plan that I've outlined on these three parts, your account will grow and your distance from financial freedom will shrink. Good luck, everybody.
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