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Time is Money—Factoring Time Value
January 15, 2016
As a stock trader, my goal is to make the largest return possible in the shortest period of time while keeping my volatility and drawdown to the least amount possible. Low risk, high reward is what I’m after. I accomplished this by buying stocks on the move, stocks that are in a definite uptrend to avoid troubled situations. I avoid “cheap,” out-of-favor companies trading near their 52-week low that may look like “bargains.”
I’m trying to spot where momentum is going to be strong enough to move the price of the stock as soon as possible at a high velocity. My major goals are to be at a profit soon after my purchase, keep losses relatively small, and avoid sitting with dead merchandise (stocks that go nowhere). I’m always trying to maximize the power of compounding.
Let’s say your average gain is 50%. The question now becomes, how many opportunities can you take advantage of in a twelve-month period? As you look over your trading results you notice that in order to realize an average gain of 50%, you generally have to hold a position for twelve-months. If you are tying up your capital for one-year, you’re only able to make one rebalance per year. While a 50% average gain is quite respectable, you may not be putting your trading capital to its best use by tying it up for twelve-months. Time, as they say, is money.
To illustrate, take a $100,000 account and assume that every three-months you realize a 20% gain. In six-months, your account is $144,000. Then in the second six-month you post two more 20% gains compounded (one 20% gain per three-months), which turns the $144,000 into $207,360. Compared to the $100,000 you started out with, that’s a 107.36% return.
In the real world, you are going to experience some losses. When we factor those in, the potential returns become even more interesting. Let’s assume that in order to achieve the 50% gain, you experience avergae downside of 16.66% (one-third of your upside of 50%). By comparison, in order to get the 20% gains, your loss runs about 6.66% (also one-third of the gain). Your batting average in both scenarios is 50%: one winning trade out of every two.
With a 50% gain and a 16.66% loss, your $100,000 account would be worth $125,010. Four 20% gains with four 6.66%% losses would increase your $100,000 account to $157,396. The numbers make it very clear: with smaller wins and smaller losses, but more frequent trades, you can achieve a much higher profit potential.
All these variables need to be taken into account as you devise the best approach for your trading: a large gain and a larger loss with fewer opportunities versus smaller gains and losses with more opportunities. It’s not all about the biggest gain that you can possibly get; rather you have to find what works best when you take into account losses and percentage of trades profitable.
Remember, the whole objective is to make as much as you can while keeping your risk to a minimum. In order to achieve that, you should aim to optimize everything in your trading. Your goal is to make the most money you can on a risk/reward basis in the shortest period of time to maximize the effect of compounding.
To do so, you must not only optimize your risk/reward, but also manage the time factor so that you are able to turn over your portfolio for the optimal return.