The Importance of Keeping Score

Do you hold yourself accountable for your performance? Does your ego keep you from acknowledging the truth? The basic premise of a successful investing strategy-particularly for short-term investing (trading) - is that by cutting losses as quickly as possible and letting profits run, over time, there will be a pre-ponderance of profits over losses.. Having losing positions will happen, no matter how well the system or the trader. It's a fact of life. To help keep perspective, a trader must constantly keep in mind that the "name of the game" is to have higher margin winning trades than minimized losses on the losing trades. Losses will happen. Even a 50% win-loss ratio can be a winner over the long term!

When trading options, traders should be constantly aware of: 1) the percentage of profitable option trades they expect to generate, as well as the profit margin of the average profitable option trade compared to the average losing option trade; 2) how many estimated option trades will be made over a specific period. With these two statistics, an option trader can get a sense for the estimated profit potential for trading options over a specified period of time. This estimation can serve as an important, measurable goal and used to help set-up psychologically expectations.

For example, let's be conservative and say that 50% of your option trades would be winners with an average net profit margin (profits less transaction costs) of 14% and losing option trades to have an average net loss of 8%; the trader can expect a net return before taxes of 6% on 50 % of the total amount invested in total trades. If the trader anticipates making 5 trades per month at an average premium of $1,000, then the trader can expect to make about $150 net profit per month (2 winning trades = $2,500 x .06 = $150). Of course this depends on how long positions are held. Annually, this would translate into $1,800 on an account of let's say $5,000 (in this example, the trader would have an account of $5,000 but only use an average of $1,000 as a maximum for each trade). This translates into an annual return of 36% on the account capital. If you have a system with a 75% win-loss ratio, then your estimated monthly return would be $225 with an annual net of $2700 for a return of 54% on the account capital of $5000. The variables are: win-loss ratio, premium capital to be used, and profit and loss margins. (In the above example if you used $50,000 in premium capital and traded 10 contracts with the same other variables, profits would be 10 times greater or $27,000. But don't quit your day job just yet.

Of course, the above example is a simplification of the option trading premise but the concept can be used to help set option trading goals to shoot for. Moreover, after each option trade is completed, the trader should track- at least: win-loss ratio, profit and loss dollars and percent for each trade and cumulative trades. Creating benchmarks and using metrics to track variations on a trade-by-trade basis is essential to help the option trader measure the performance of the system; moreover, the option trader must assess how closely trading parameters and procedures are followed for each trade.

The idea is to track the option trading system's performance and not the trader's. It's like using a mathematical function; use a consistent system of indicators and plug in the numbers and look for a consistent result. If the trader alters the parameters and procedures, it only measures the option trader.

The idea is to identify high probability option trades and use consistent option trading procedures. If the trader's system is good, it will produce a win-loss ratio of over 50%. Some successful traders who have learned to identify high probability trades and execute an option trade with consistent discipline have win-loss ratios above 70%.