Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational...
Why P&L Doesn’t Determine Success
04/11/2011 3:00 pm EST
Risk management expert Mike Toma says bottom line isn’t even in the top ten measures traders should use to rate their success in the markets, and discusses other, more important metrics to watch closely.
A lot of traders simply use P&L, their profit/loss statement, to determine their performance for the year. That's one way of course, but other ways that we can look at the accuracy of our success as a trader. Our guest today is Mike Toma; he's here to talk about that. So Mike, is P&L the only way to benchmark your success?
No. In fact, I wouldn't even look at that as one of my top ten key performance indicators.
A lot of traders actually use win/loss as one of their key performance indicators. Really a key performance indicator is the measure that you look at to measure how you are running your business, the business of trading, for instance.
But I actually look at P&L, win/loss, as a rather poor indicator of how a trader is defined as successful. Again, I've seen traders who have 80% win/loss or high profit margin, but if they're putting themselves at risk or undue risk, maybe it's just a car going down a hill ready to hit that cliff.
So sometimes in the early stages of trading, people get excited about P&L, particularly when they break rules to do it. That's not really the way to go.
Isn't that what this is all about? We're all here to make money, right? So if I'm making money, aren't I successful?
That's a good point. No, it's not actually. Probably discuss some banter on that, too.
From a risk perspective, what I'm looking for more is how you are rating the core of your business. For example, in a restaurant, it's not just about how good the food is. It's about the staff, the quality, the timing, presentation, and the location.
There's a lot of internal mechanisms that I want to measure that will determine my success or the success of another trader. For example, how about trying a metric where I want to look at the average gain in that, but compare it to the average loss.
So you talk about P&L: I'm having profits in this one set-up. How much are you losing when you're losing in that set-up?
So, for example, if I have a profit of four points on the ES futures on a winning trade, but I have a two-point loss on the losers, I can have a 50% success rate and still be okay. Conversely, if I have two-point winners and four-point losers, even though the winners are happening 70% of the time, I'll probably be out of business sooner than later.
Alright, so other than the number of wins and losses and the averages, what else are we looking at? What other things can we benchmark our trading success?
Risk control. It's very important.
I want to see how much are they risking on a trade in comparison to their capital account. Again, six winners in a row looks great, but if they're risking 20% of their capital, you want to be able to manage those drawdowns and the randomness that occurs in these markets. Very important.
I also want to see are they taking undue risk at times when they shouldn't be, such as before news events, or are they breaking plan rules. Very important.
It's more important to be consistent or really err on the conservative side. Since the markets are always open—they're not closing anytime soon—it's okay to conservatively chip away at a plan that's going to gradually build your business. Not necessarily get those P&L in the first days or the first week.
Right because those could be maybe a string of being lucky on those trades or just a raging bull market if you're going long. I guess this is a way to make sure you have success long term.
Yeah, I see it all the time. They start out great and all of a sudden they build these P&Ls for week after week and I see this drawdown in one day or one week. What happened? Plan compliance? Probably, but again, P&L is not going to measure that effectively.
So how do I then gauge this? Is it a trade journal, a spreadsheet? What do I do to actually track this stuff?
You can do a trade journal, spreadsheet. I tend to keep it simple. I have some high-tech gadgets I love to play around with and some good risk analytics tools.Really if you have these metrics and you follow them and measure them, and more importantly, learn from them, that's how you really build yourself; not as a trader, but you’re really building your business as a trader.
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