What does it take to achieve 20% return in a year?
Let’s make a few assumptions first. Then we are going to elaborate on why and how.
Initial assumptions:
60% win rate; therefore loss rate is 40%
average winner: 10%
average loser 5%
average position size (capital allocation) = 7%
average holding period = 5 days
What is the average contribution of each trade taken under this approach:
Capital allocation * [(win rate*average winner)-(loss rate*average loser)]
7%*[(0.6*10%)-(0.4*5%)] = 0.28%
The average contribution per trade is 0.28% of total capital.
This means that in order to achieve 20% annual return, we need to take 20%/0.28% = 71 trades per year
Or about 1.4 trades per week
There are 5 Major Ways To Improve Our Performance:
1) Improve our win ratio – some might say that at 60% it is already too high and there is not a lot of room left for improvement. The win ratio is not static. It could change substantially over the year, depending on the market environment. If you know that under certain circumstances your win ratio drops below 50% and your average winner becomes smaller than your average loser, with other words your system loses its edge – then it makes sense not to trade at all during such environment.
For arguments sake, let’s assume that you could drive your win ration to 70%, while keeping all other factors the same:
The average contribution per trade becomes: 7% [(0.7*10%)-(0.3*5%)] = 0.39%
To achieve the same 20% return, you will need to take about 51 trades or about 1 per week.
If you take 71 trades under the same system, your annual return should be about 27.7%
2) Increase the average size of our winners – it depends on market environment and holding period. Increasing the size of winners might requires using wider stops and therefore increase the average size of our losers. Holding longer might decrease the overall number of trades we could take.
For arguments sake, let’s assume that your average winner become 12% and everything else remains the same.
The average contribution per trade becomes: 7% [(0.6*12%)-(0.4*5%)] = 0.36%
To achieve the same 20% return, you will need to take about 55 trades per year.
If you take 71 trades under the same system, your annual return should be about 25.5%
3) Decrease the average size of our losers – it is already pretty low. Using tighter stops might hurt our win ratio and take us out during normal market fluctuations.
4) Trade more – when you trade a system with positive expectancy, more trades equal higher overall profits.
For example, if we take 200 trades or about 4 per week under the original assumptions, the annual return would be 56%
This is derived from average contribution per trade of 0.28% * 200 trades
Of course, trading more might lead to a decline in our win rate and in our average winner. Also, our system might not produce as many trade signals. Also, trading more has very steep opportunity cost – the time you spend trading actively is a time you could spend doing something else, which could be another source of income.
5) Allocate more per idea: the original assumption was for 7% capital allocation per idea. With the average loser at 5%, this means that our average loser is eating 0.35% or 35 basis points of the total capital.
If we bump the average allocation to 15% and everything else remains the same, then
the average contribution per trade becomes: 15% [(0.6*10%)-(0.4*5%)] = 0.6%
To achieve the same 20% return, you will need to take about 33 trades per year.
If you take 71 trades under the same system, your annual return should be about 42.6%
Capital allocation doesn’t need to be the same – it could vary depending on the asset, the market environment and the overall risk you would like to take. As a general rule, using tighter stop losses increases your position size, but it is also likely to decrease our win ratio. You have to find the best system for your life style and experience.
