A few posts ago I wrote (here) about how your position size/commission size ratio can greatly effect your returns, and how I made the mistake of using a system designed for a much larger position size. Basically, the smaller your position, the bigger the commission amount has on your profitability, which means you can’t make money on tiny wins.
I thought I’d drive this concept home with some stunning graphs and charts.
Below you can see the results of a simple swing trading system that buys the S&P 500-based ETF (SPY). The first two graphs are unrealistic in that they don’t include commission fees. They’re pretty graphs, yes? Money keeps going up. I like when that happens, even if it’s pretend.
And note how the graphs are congruent, in that they’re the same shape with just different start points and endpoints. I’ve used two sets of position sizes: the first has an account of $100,000 and position sizes of $10,000, and the second one has an account of $10,000 and a position size of $1,000. None of these tests allow compounding.
And now we wake up from that wonderful little dream and pay some commissions to that nasty stock brokerage. How dare they make money on our money!
Here is the same trading system, using a $4.95 commission for each buy and sell. The graph is a little more ragged than the fantasy graph, with substantially less profit, but it still looks pretty good.
Alas, the same can’t be said for the smaller account. In fact, one could say the trading system “fell off a cliff”. A more technical way to describe this system is “broke”. Which also describes your account.
“Holy banana-pants, Batman!” you probably just yelled. (That’s what the kids say these days, isn’t it?)
So why does this swing-trade system suddenly suck? (Which is another technical term, used to describe a system exhibiting continuous adverse excursions). It sucks because it has a profit target of 0.2%. Yes you read that correctly. It has a wonderfully high hit ratio when large positions are used, and makes money the old fashioned way (slowly, a bit at a time). But when a small position size is used, those commissions often turn a win into a loss.
Let’s see, $1000 * .002 is $2, minus commissions both ways at $4.95 * 2 = $9.90, so that makes my profit…uh…negative $7.70 for a ‘winning trade’. Let the swearing begin.
Whereas the larger account would have made $20, and then spent $9.90 in commissions, leaving a small (but real) profit of $10.10.
In fact, this system only tips over into profitable territory (and we’re talking $11 profit over the entire 15 years of trading) at the $1300 mark for position size. I ran the position size as an optimization variable, and here’s a chart showing the results:
Commissions have a very real effect on the ability of a trading system to make money. And the smaller the position size, the bigger average return you need per trade to make it profitable. Which can most easily be achieved by using systems that hold positions for longer.
Does this mean as I get richer, my trades get shorter?
For those of you with $10k to invest per position, I’ll bet you’re chomping at the bit to get your hands on this trading system, right? Well here’s a link….