What makes a profitable trader?

Let me start this blogpost by one of the statements made by Nithin Kamath, CEO of Zerodha and I quote him “Trading is one of the toughest businesses to make easy money”. He has said many times on public forums that only a handful of active traders are able to beat FD returns over a period of 3 years or more and that 95% of the traders either go bust or are barely breaking even. In my experience, I have talked to so many traders who are trading full-time for a living and I have never seen any of them say trading is easy. It is akin to any other business; you talk to those folks and ask “Dhandha kaisa chal raha hai?” and invariably their answer will be it’s going tough and nothing great about it. And that’s how the reality is — Trading is tough, accept it.

On the other hand, there are folks who glamourize trading or tell you how easy trading is. They’ll be posting the pictures of the beautiful penthouse they just bought from the trading profits or the BMWs or the Mercs or the pictures of them trading from a beautiful beach in Bali. If you observe carefully, you will find one thing common in all of these folks — they are selling you something. It could be their trading calls, their perfect indicator that they use or the whole 2-days mentorship program. I have ranted enough about these folks (I call them farzi gurus aka furus) in my earlier posts so I’ll leave this be.

But if you aspire to become a full-time trader or you wish to trade profitably part-time while continuing to focus on your main source of income, be very sure about what you are getting into as trading is NOT easy, period.

With that context set, let us see what really goes into profitable trading.

1. Trading Edge — What is a trading edge? Anything that gives you a positive expectancy over a large number of trades can be called a trading edge. Let us further define each of these. Positive expectancy simply means that if you sum up all your trading gains and losses, you make some money. Large number of trades here means that after a series of losses, you should still be able to take the next bet i.e., you stay in business despite making continuous losses. Let’s take an example — there’s a fair coin and you place a bet of Re 1 every time it’s tossed. If it’s a heads, you make 2 Rs and if it’s a tails you lose your 1 Re bet. Do you think you could make a fortune if you had Rs 5 in your pocket and you played this game? Not sure, right! How about we make it Rs 50 to start with? Now you are fairly confident that you will make it through. What if your initial sum goes up to Rs 1000? All of a sudden you should be very confident that with the kind of system you have you are going to survive even in case of an extreme events and rightly so. The probability of you busting in the case of 1000 tosses is miniscule. You can play around with these numbers on this site Coin Flip Probability Calculator (omnicalculator.com) and check yourself. So, this system wherein we make 2 Rs every time we win and lose 1 Re every time we lose, with a theoretical chance of 50% winning gives us a trading edge if we are able to place 1000 bets at least.

Now that we have established what a trading edge is, it is very important to understand that one needs a trading edge to make money from markets, no matter what. It’s the very basic thing and yet ignored by most retailers that the first and foremost thing needed to make money is trading edge. Randomly taking trades and placing bets based on your intuition or your favorite TV expert’s recommendation or on telegram tips you have subscribed to or on randomly drawn lines won’t make you profitable. Earlier you understand it in your trading career, the better it is.

2. Execution — Now what’s execution? Surely you all know what execution is in trading. It’s simply placing the trade, right. Yes, and much more. Execution is to be able to place a trade without any bias. Once you have established a trading edge or a system that you know works, the next important thing is to be able to take trades, adjust those trades if needed (trailing stop loss, reducing allocation, etc.) and exit the trades day in and day out.

Assume you have a system that recommends you to go long on a close above 10 period high. You have backtested this system and this has a trading edge. Comes Covid and you see the big crash in markets with the Nifty going from 12400 to 7500. You see markets recovering while the fear of Covid still looming large and you get a buy signal on 9th Apr when Nifty hovers around 9000-mark. Will you have the courage to put that trade given what was happening all around? Similarly, if you are running into a severe drawdown yet an acceptable one as per your backtest, would you still be able to execute that next trade without any bias? If the answer is yes, you are ready for it.

That brings me to the rule number 1 of trading — “If you don’t bet, you can’t win” — Larry Hite.

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3. Position sizing — You can afford to mess up with a trade and place a bad trade, but you can’t afford to mess up with sizing a position. Markets are not forgiving. Position sizing tells you how much to bet for every trade that you place, what’s at risk. It’s the cricket world cup 2024 and assume a minnow team Scotland which gets to play their first ever world cup is facing mighty England who is the top-ranked team and the favorites. You are asked to place a bet and you know that England in all probability is likely to win the match, something that has a hypothetical probability of 99.9%. Also, hypothetically you make 1 Re for every Re you bet if England wins. How much do you think you should be betting if you have a 100 Rs account? Such opportunities come very rarely so you must be thinking all-in and that’s where things could go wrong. For that tiniest probability of England losing, you can’t be risking as much money which results in a severe blow to the account.

While this drawdown number could be different to everyone but personally to me 20% is an acceptable drawdown in case of a black swan event and anything up to 30% would still be acceptable in rarest of rare cases but anything above 30% and you are risking going out of business. Recall our discussion in trading edge — it’s all about the survival.

And that brings me to rule number 2 of trading — “If you lose all your chips, you can’t bet.” — Larry Hite

4. Risk Management — Profitable trading is all about managing risks at all point in time. Every time you put on a trade, the first question that you should ask yourself is what’s at risk and not how much you can make? There are many ways you can make money from trading in the long run but despite making money from trading for a fairly large period of time say 5 years or so, it could all go wrong one fine day, and you can end up blowing the capital. This I’d like to call making money trading through bad methods.

Let’s consider an example — We all know indices don’t move much in a day or two or in a week. We have weekly contracts in Nifty and if you could technically sell 8–10 delta strangles in Nifty every week and make about 1% a week selling those based on margin it needs. Selling 1 lot requires about 1.3L margin but that means taking a leverage of 7–8X as the notional exposure of Nifty is 9.5L. It all works well until that one fine day when index opens at a limit down/up of 10%. That is when one can easily lose 40–50% of their entire trading capital and that’s precisely what I would call a blow up. Remember anything above 30% is asking for trouble. I have found two things common in almost every blow up of big funds, institutions that I have read about — concentrated and overleveraged bets.

You should evaluate your trading methods from time to time even if you are a profitable trader and see if your trading methods are sustainable in the long run? If not, it’s time you changed.

That is all you really need to be profitable! I haven’t talked about any strategies here because markets evolve. What works today might not work tomorrow so it’s your ability to adapt to the ever-changing market conditions which will keep you ahead of the rest.

I would like to conclude this blogpost by telling you something about the role luck plays in trading. This story goes back about 15 years or so when the majority of the trading used to happen through call and trade methods where clients would call their brokers to place a trade. I know someone who had a concentrated bet on a stock, and it was up 4–5% so he wanted to get rid of his holding to lock-in gains. He called up the broker, gave them the exact quantity to sell the shares but instead the broker placed the buy order. Next day broker asked for the payment check and client was shocked to learn that the shares were instead bought. But to his pleasant surprise, stock was locked-in on upper circuits for the two consecutive sessions and he could sell his shares on the third day with handsome gains and that too on extra quantity that got bought by mistake. While some days you would get lucky, there are days you would be unlucky too so it might just even out in the long run. The only reason I am highlighting this is to make you aware that luck is not something you would need in the long run to make money from trading, but you would want it to be on your side.

Happy Trading!!