Trading like a business

Updated: Sep 10, 2020

I have often heard trading gurus say that you should treat your trading like a business. Sounds like a smart idea. Recently I put some thought into this idea. What do they mean by this? After thinking for a bit I came up with my own interputation of this.

Trading might have the lowest barrier to entry of any business that one could get into. Someone could start trading with very little trading capital. Profits will vary depending on account size but percenatge wise a small/new trader could do just as well as a pro.

Like in any business you need to be competitive in the markets you enter. To do this you must be intimately familiar with your stocks (your product). Keeping up with company news, events, catalysts and financials is extremely important. In addition, economic news, macro events and trends that would impact your stocks are critically important to be aware of.

Assuming you have done your due dillegence/ research you are ready to buy some inventory. Just like a retail store you want to keep an inventory of products that will be in demand. In this case, stocks. As a retailer you probably wouldn't load up on last year's models as they have already had their time in the spot light and will likely fade out with out new catalysts. Imagine being stuck with an inventory or fidget spinners or beanie babies that you had to sell at a big loss. So you need to look ahead to the "next model year" or the next "season".

After you decide on the stocks to carry you need to asses your risk and buy an appropriate inventory of each. You will also need to establish a sales price for each (price target). To control your risk and protect yourself from failed products you must size your positions accordingly and carry the proper amount of inventory to meet the demand. At this point you are set up very much like a retail store which sells certain stocks at a price determined by you. Obviously you want to sell for more than you paid for the stocks.

Sometimes however, you get stuck with the proverbial turd. Most stores slash prices and try to sell under performing inventory quickly. This is a smart idea in trading too. You want to sell your stocks at a profit ASAP and move on to new opportunites. Holding on to underperfoming stocks simply ties up capital that could otherwise be used for better opportunites. This includes selling your losers before they become total turds.

Comparing stock trading to retail stores is pretty simple. I think most people see similarities. Retail, however is not known for the best profit margins in most cases. This got me thinking about what businesses are better than retail and how I could draw comparisons to trading with those businesses.

After thinking about it for a while I came to the conclusion that some of the most profitable industries are: insurance, gaming and leasing. How can we draw comparisons to these industries with trading?

Inusurance. Traders interested in "insuring" their portfolio often buy puts to hedge their positions agains potential downside. So, by selling puts you are in essence acting much like an insurance company would. You are paid a premium to protect the buyer from downside risk. By selecting quality stocks that satisfy your criteria you could potenially create a steady revenue stream of premiums that you collect either weekly, monthly or quarterly. Insurance companies are profitable because they collect more in premiums than they pay out in claims. In a worst case scenario you have a "claim" in which case you buy the stock from the "insured" at the agreed upon price while still keeping the premium that was paid. If you selected a good candidate this should not be so bad since it is likely a stock that you wanted at or near that price anyway.

Gaming. In the long run the house always wins. There are statistics that prove that the casino's slight edge accounts for big profits in the long run. In terms of trading options sellers have this edge as well. Most out-of-the-money options expire worthless most of the time. Accounts vary as to the percentage but 80% is often used as a fail rate. Regardless if its 50-80% the odds are in the options sellers' favor. With these odds you can sell short term (weeklies work well) OTM calls with a high rate of success. Candidates for this approach should be relatively volatile with a weekly option available. (Selling calls without owning the underlying stock is very risky). Worst case scenario you have your shares "called away" from you and you miss out of potential profit.

Leasing. I compare selling covered calls with a longer term until expiration to a rent-to-own business. Ideally this is done on stocks you already own and plan to own for the long term. Selling calls with longer periods until expiration equals higher premiums. Ideally you would already be in the black on these holdings and by selling calls on your stock you could create addional returns on your investment. Depending on the calls you sell, statistically you will profit more times than not. Hopefully you can repeat this process of collecting call premiums several times without having your shares called away from you. Worst case you keep your premium and sell at a profit.

In conclusion trading like its a business can take several approaches. Whatever suits your risk tolerance and objective should be your primary approach. I have decided that a mix is the best strategy for me. Capital appreciation from my "retail" business and passive income from my "insurance", "gaming" and "leasing" business is the way I am leaning.

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Nothing particular is catching my eye today. Markets have been a mess. I will be sitting out today.