The Problem with Small Profits
The Problem with Small Profits
There's an old saying that you can never go broke by taking profits. I believe that statement to be true, as long as the profits outstrip the losses by a ratio of at least five-to-one. I see too many traders who are very happy to capture small profits, as the immediate gratification of making any kind of gains makes them feel good. The issue they encounter is that those small gains, over time, cannot compensate for the inevitable losses that are a natural consequence of trading, and the costs associated with trading.
Let's stop and think about why looking for bigger moves, rather than taking small profits, will help improve the overall results from trading. For starters, how much do you think an average trader pays in commissions each year? Add to that short-term capital gain taxes that have to be deducted if one does well. In addition, there are the mandatory data, and internet fees that must be accounted for. Some would say that it's just a cost of doing business, and I would agree; however, so many traders I run into don't place much thought, or really realize how much those costs really are. I think if they did, perhaps they wouldn't be so eager to take meager profits.
When we sit down and run some numbers, the reality may be eye opening. First, the commissions: If we estimate that a beginning trader will most likely trade one contract, at $5.00 per round turn, and (we'll make a conservative assumption) that she will only make 3 trades per day, the total commissions she will pay in a year (roughly 250 trading days) are $3,750. The data feeds and internet service provider usually run around $100 monthly, and lastly, taxes are about one-third of the gains. If we add it all up (I'll let you do the math), it's clear that a big profit-to-loss ratio is imperative if we expect to keep any profits - that is unless we have a high win/loss rate.
A select few will hone a scalping skill set where the win-to-loss ratio is high (over 80%), and the profits are very small. This particular strategy could compensate for the costs of doing business. But I have to tell you, I've met very few of these Uber-traders that can consistently make money doing this type of trading for any extended period. For us mere mortals, the odds are more like a sixty-forty win/loss ratio. If that's the case, then it becomes imperative to implement a strategy that affords us those high profit targets.
I receive a lot of inquiries about why I choose to trade the (TF) E-mini Russell 2000 futures contract versus some of the other contracts such as the ES (S&P 500 E-mini), even though it trades much less volume. The main reason I love the TF is because of the big moves it makes. At $100 a point in the Russell, I would have to buy two contracts of the ES to get the same Dollar move.
The charts below show the contrasting movements in Dollar terms between the ES and the Russell. Also important to note is the velocity of the move.
The Russell E-mini is not for everyone. Yet, in terms of riskñto-reward, few contracts will compare. It is not my intention here to convert all you ES traders to trade the Russell, but rather to show alternative trading instruments that will give more bang for the buck.
Along the same lines of looking for bigger profit targets, the areas where we enter our trades should be a good distance away from the profit targets in order to achieve a fiveñtoñone profit objective. This can only be achieved by exercising patience in waiting for these setups, and not just taking any trade. In the charts above, I've detailed these wider profit margins.
From a psychological standpoint, it can be very tough to hang on for the longer rides, as the market will try to shake out the weak hands at every turn. I believe it requires more discipline and mental fortitude to stay with the big winners than it does to accept losses. Having a set-itñand-forget-it plan may help in that respect.
In short, only by learning a low risk, high reward strategy, executing it properly, and trading the right financial instrument, can you overcome the inherent costs of trading.
Until next time, I hope everyone has a great week!
- Gabe Velazquez
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