If you were contemplating starting your own business, would it be wise to do so if you had little idea about what type of profit margins you would have in the business? Moreover, would you embark on this endeavor without a sound business plan? You all know the answer to these questions, and yet, why is it that when it comes to trading (which should be treated like a business) not many traders consider profit margins when putting on trades.
In any operation that engages in buying and selling merchandise, it’s simple math that dictates whether a business is profitable or not. A basic example of this concept would be that of a grocer. He will buy tomatoes directly from a vendor, in this case a farmer at let’s say $1.25 a pound. If he charges $2.50 a pound he has a profit of $1.25 per pound which is a 100% markup. The markup (the difference between the price he pays and what he sells the tomatoes for) is the profit margin. For the most part, the grocer is not in the business of predicting the future price of tomatoes, he just needs to manage his inventory and sell as many tomatoes at a good margin as he can while staying competitive with other grocers. There is however, a scenario where the grocer will lose money on a batch of tomatoes. That is, if increasing supply causes the price of tomatoes to suddenly drop to fifty cents a pound. If he’s caught with a bunch of inventory which he paid much higher prices for some of his competitors will buy the cheaper tomatoes and sell them at lower prices. This in turn will cut into his profits because he will have to lower his prices to stay competitive. If the price he sells them is below cost he will lose money. If he manages his inventory properly through all the inevitable price fluctuations, in the long run, he’ll stay profitable.
It’s not any different in trading. Buying low and selling high is the only way to stay profitable. As simple as that sounds, why is it so challenging for traders to stay profitable? Think about the last time you went long an S&P E-mini futures contract. Before you placed the trade did you have a mechanical process to project a profit target? Did the potential profit warrant the risk you were putting on? Do you understand the concept of probabilities, and that it takes a larger sample size to ascertain the viability of any method? If you answered no to any of these questions then I would venture to guess you’re trading is not profitable.
Here at Online Trading Academy, we teach a method based on the immutable laws of Supply and demand. We use this not only to find low risk entry points but also as a way to measure profit potential. The details are beyond the scope of this article but here is an example of what we did in one of the XLT classes I conducted last week.
This was a short setup in the EC (Euro currency futures) that students participated in. We found a high quality area where institutions had shown us that they had sold a large number of futures contracts (supply). We placed a limit order at the bottom of the zone (before price returned to the level) and a stop above the upper end of the zone in case we were wrong. Now, the profit target (the blue line) was done by measuring the distance between the entry and where prices were likely to turn higher. This is accomplished by using various factors that give us a specific target price. You’ll notice in the chart below that price fell much further than our projected target. We’re perfectly fine with that as long as the rules of engagement are applied.
In conclusion, trading has to be treated like a business and there must be a system in place to measure the profitability of all the trades that are taken. And similar to a business, which incurs costs, and won’t make money on all transactions, a trader must keep losses small and profit margins wide so in the long run profits will be more probable.
Until next time , I hope everyone has a profitable week.