## Tuesday, January 26, 2010

### A Two Iteration Monte Carlo Simulation on Trading

This is something that I have posted in a comment some time back. I thought I would just expand it for discussion and see if it makes sense.

First let’s work through some assumptions and no.s and see what’s the expected return for trading.

1. The capital base is \$100,000
2. \$10,000 is utilized per trade
3. 10 trades is done in 1 year
4. Take profit at 20%
5. Cut loss at -10%
6. Winning rate 60%
7. Transaction cost \$20

Based on these:

a. The 6 winning trades will bring in \$12,000.
b. The 4 losing trades take away \$4,000.
c. Transaction cost is \$400.
d. Total winnings: \$3800
e. Return 3.8% - Yeah that's life for a trader, my darling. Why don't you put the money in CPF and earn the same return?

Ok, there are a lot of assumptions, some might be skewed to put traders down. After all, this is a value investing blog. :) What if we tweak them around? Say the capital base is just \$20,000 – then the return becomes 20%! However the rationale would then be it won’t be possible to realize 10 trades in 1 yrs with just \$20,000.

Anyways let’s do a more aggressive one

1. The capital base is \$50,000
2. \$10,000 is utilized per trade
3. 10 trades is done in 1 year
4. Take profit at 15% (rationale being that the time horizon is now shortened)
5. Cut loss at -10%
6. Winning rate 60%
7. Transaction cost \$20

Based on these

a. 6 winning trades will bring in \$9,000
b. 4 losing trades take away \$4,000
c. Transaction cost \$400
d. Total winnings: \$4,600
e. Return 9.2%

Ok that’s better than market return, but that’s probably also a high hurdle. To do 10 trades with \$50k in 1 yr, reach trade can only go for 6 mths.

I think the appropriate scientific experiment we should do is a Monte Carlo simulation of 1,000 iterations to see what’s the true expected return. But my guess is it’s actually going to be less than market return (of 8% or so). Yes, actually if you do it correctly, a trader should earn positive return, not negative ones. And in all those books, it always says academic studies show that trading cannot beat market return after factoring in transaction costs.

Well this also implicitly means, if you get your transaction costs low enough, you might beat market return and becoming a Big Swinging Dick.

Ok, daydreaming over. Trading is hard. My sense is, it is actually much harder than value investing. If you do it right, you might just make average return. Most people don't do it right in the first few years. Think about the time and effort that is needed to execute these trades during the year. Basically it’s a full time job in itself. Not forgetting that it's gonna be one helluva emotional rollercoaster ride every day!

Well, that’s why I stick with value investing.

1. Yeah trading is tough, yet huge amounts of people try all the time. This is what amazes me. Why try so hard at trading when you can just invest and have more peace of mind?

2. It's hard to understand why people venture into trading. It's better to ignore it totally. I think the reason is the innate nature of human to strike it big through gambling which derives both satisfaction for short-term gain and also the thrill.

Maybe some of them really can make some money, but I know none. But I trust there may be some really good successful traders, just like good successful poker players, who perfect the skill of counting cards, and know when to hit it big and when to withdraw.

As for me, I stick to what I understand best which is to price things rather than time motion.

3. but hw long should u hold an investment to be considered not a trader?
i heard buffett holds an average of more than 17 years whereas our local T & G who are long term investors buy at peaks, hold for a few months and sell at the bottoms.

4. Hi Musicwhiz, Berkshire

To someone who had never look at stock markets, trading definitely sounds easier to master than value investing. Just look at charts instead of reading tons of annual reports. That is one reason.

Of course, it doesnt help when the brokers always encourage trading, provide tools for drawing all those trend lines, and also conducting courses on trading - which of course helps with their revenue.

I also believe there are good professional traders around. They perfected the art of timing motion. For the rest of us, better stick with good old value investing.

5. Hi Lau,

The length of time to hold a stock does not determine if you are a trader or investor. It is the philosophy.

If an undervalued stock goes up 100% in one day, and reaches its fair value. The value investor should sell it.

However, speaking on average terms, individual stocks move around 20-40% in 1 year. Hence for a value investor who usually looks for at least 50% upside, he/she on average has to hold a stock for more than a year. Most books say around 3-5 yrs for stocks to reflect their true value.

For a trader who looks for 20% upside, on average his holding period is around 3mth to as long as 1 yrs.

That's the long answer.

The short answer would be on average 3-5 yrs for a value investor.

Buffett holds for a much longer time frame bcos the value of his core stocks grow over time, exponentially. See one of my post on buy-and-hold talking about Coke and See's Candy.

Hope this helps!

6. On T&G,

Well G didn't sell their stocks. So actually they put their money where their mouth is.

As for T, it is easy to say on hindsight that it was a mistake to sell at the low.

But at that point, the decision was whether to sell to recoup the remaining USD 1bn or to see everything get wiped out. After all, it was like maybe 80% chance that the stock would go to zero once the firm gets nationalized. What would you do?