As we are now beginning to understand, Capital measurement is not an easy matter to resolve. I would like to make some further observations or comments to add into the debate.
In my previous life I was a banker, & if you came to me and asked for money or capital to start your business, I would have charged you interest on all you borrowed from me, not just the amount you used to buy your initial stock or trades.
When you trade for a living, your trading account is your capital, and in order to manage the financial health of the firm, we need to look at two core elements:
- The first is how much should I buy my raw supplies for, and in turn sell my product for . This equates to the net difference between the opening and closing of a trade. In this instance we need to look at the cumulative P&L from all the individual sales (trades), and make sure we are net positive dollars. Now the important thing to realise here is that when you come back to me as your banker, I am going to ask "... how did you do this month ? ...".
Now do not be fooled by my nice smile and the pleasant enquiry about the family, what I really want to know is, how is the business going, did you get an adequate return on the capital I lent you, can you pay me my interest and will you be able to pay me back my money?.
Whilst I might be interested in your marginal return on each trade, I am really more interested in the bigger picture. If things are not rosy in your garden, I might start thinking about handing your account over to the Credit management team, and these guys are like Pit Bulls. They will take a big interest in your sales margin and in how you run your business, because they will want the banks money back and will not think twice about restructuring it from the ground up by each sale (trade) and the margin on each sale or trade and in many cases you may find yourself restructured out of a job.
- The second, is at the end of the month, how did you do financially ?, Were you up on sales or down ?, What was your ROA.
The above harsh reality of meeting your banker now raises a split in how to measure Return. Clearly all of the capital is at risk, even if we are not using 100% of it. Remember the banker ? Capital is not free and he will want a return, so all sales (trades) need to generate sufficient return to show a healthy business growth.
So we now know we have some decisions to make on how to measure our firms success. Investment theory, and in particular, Discounted Cash Value analysis,(DCF), Net Present Value, (NPV), & Portfolio replication theory, (PRT), are areas that we will find helpful here.
In large companies there are always more projects demanding funding than management can squeeze out of the Board. So how do we decide one project over another. In this instance, we can look at a Discounted Cash Value (DCF) for each project and rank them in order of the best to the worst return.
Now I know this might be new to some people, but hang in there it is not quantum physics, and it is reasonably easy to understand. What happens, is all the project incomes are entered into a spreadsheet for each month going out over the life of the project ( say 36 months) next you subtract all the costs generated by the project on a monthly basis for the same period. This leaves you with the net cash position in future dollars for your project cash flow over the life of the project. This is the hard bit - each monthly number is now multiplied by a number that effectively takes the future dollars and discount them to today's dollar value. These discount factors are mathematically worked out and usually found at the back of any good stats book.
Right now we have each of the future cash flow values now converted to their current dollar value or the Present Value of all the future cash flows from this project over the future life of the project. Each of these numbers is now aggregated into a single number called the Net Present Value (NPV), that can be compared between competing projects. Companies rank all these projects from the best return to the worst return and spend their capital on each project in the list until the allocation of funds runs out. Using this method you know you are optimising the potential returns on capital by choosing the most productive projects that offer the highest returns for the capital invested.
All interesting stuff - but how does this help my trading business - well the point I am attempting to make is that there are two measure we need every month to help us run our business - a monthly optimised trade target and the overall return of the business activity on the Capital lent to you by the bank to start your business up. We now have TWO measures not One.
One thing to keep in mind with Capital when grappling with the issue of
:
"... but I only used $5,000 of the $10,000 you lent me, why should I pay interest on the full amount ...?"
Going back to the DCF analysis above - a core assumption of this methodology is that Capital is not free and if it was not used in this project it would have been allocated elsewhere or invested in stocks, bond, futures etc. A bank will not leave funds idle - so if the bank does not lend to you - we will lend to your neighbour - we will get our return on our capital with or without your deal. So here is a fact :
Capital is not free you have to pay.
Lets now look at some ways to calculate a monthly target for each trade and see how this target would combine up into a suitable Return on Equity sufficient to please me as a banker.
In finance there is a rule of thumb called the "rule of 72" - in simple terms if you borrow money at 6% per annum, by dividing the interest into 72 you get a rough rule of thumb as to how long it will take you to pay back the loan. In our example 12 years. Lets re-engineer our thinking and use the rule as an investment guideline. In this instance if I aim to get 6% from each trade I should double my money in 12 months.
OK so far - but wait there is more ..... What about my poor risk to reward ratio of 50/50 - well we can scale up our target of 6% by our 50/50 R/R to now give us 12% target for each trade.
But hold on - what about the tax man - I am on 30% tax, so by dividing the 12% by the amount of money I get to keep after tax, 70% ( 100-30% = 70%), we now have a target rate of 17% for each trade.
As you can see, we can keep refining our target rate to reflect the complexities of our business. However the main point is that if each trade gets 17% we will double our money over 12 months and for some trades like Calendars - 17% is not an extraordinary target, but might be for an Iron Condor.
Now we need to do the same at the portfolio level and at this level we need to take into account how all our trades have impacted our total available capital because we need to make a salary and cover all our bills - including the friendly smiling bank manager ( & OK we can include the tax man but we ware stretching the bonds of friendship here). So how can we attempt to create a sensible target - using the same method as above will give us a similar number to the 17% and this is potentially unachievable on a consistent basis for most businesses.
Well, one of the ways we can move ahead is to look at the minimum rate that we need to cover our costs - Firstly lets say that the bank interest on our capital is 6% per annum and that we need say $2,000 a year to live on ( assume this is one of Dan's blind squirrels that made all that money back in the 90's doing their budget). Essentially the principle would be to convert each of the numbers into a monthly rate. The 6% becomes 0.5% and the $2,000 equates to around 4% (Our capital, remember from above was $10,000) is around 2%. Also lets say we had accumulated business costs of another $1,500, which equates to 1.5 %. If these were the only requirements impacting the business we can start to get a feel that a portfolio target of 4% will cover our Cost of Capital, ( interest payments to the bank), all our bills and income needs.
The beauty of this measure is that it is risk adjusted because the monthly returns have already taken risk reward and tax into account.
An alternative to this aggregative rate method to calculate a portfolio return might be to look at another financial method called Internal Rate of Return (IRR). Under this method we could look at how much income we need each month and use similar discount factors to those used to calculate the NPV. However under the IRR method, the cumulative forward monthly cash flow requirements are reduced to a single rate of return that would generate the amount of income we would need for the year.
Whilst there is a lot here to read, the concepts are still very much of the Keep it simple stupid (KISS) principle. Even Dan's blind squirrel can use these concepts to calculate how much capital he needs without losing his nuts!
Cheers
