Trading Objectives

Introduction

Why set objectives?   Well, the simple reason is that if you don't set goals, you are not likely to achieve them.  Whilst setting goals doesn't guarantee that you'll achieve them, not setting one virtually guarantees that you won't meet them.

Good and Bad Objectives

The problem with objective setting is that there are so many "bad" (e.g. incomplete) examples out there, that it isn't funny.  Many of the simplistic "how to" guidelines out there are well-intentioned, but the problem is that they are too simplistic and have not been battle-tested over the longer term.

For example, a young trader once told me that they set objectives.  They have it down in writing (a good start)   They have a specific target return, with a specific time target, which can be measured (also a good start).   However, once they start trading, after a while, they find it "useless".  Their actual returns never match their objectives.  They decided that they cannot control the returns from the market - it's like as if the market doesn't really care what their own individual objectives are!

Does this describe you?  If so, don't give up.   I would contend that most likely, whilst you are doing a few of the right things, there are still some more things that you need to learn and fix.   However, let's start with the basics.  What are the characteristics of a good objective?

Good Objectives are at least SMART

If you google "Characteristics of a good objective", you will frequently end up with "SMART" acronym.   SMART stands for Specific, Measurable, Achievable, Realistic, and Timed.  It is beyond the scope of this article to explain this in detail, and my assumption is that readers reading this article have at least some personal experience in setting SMART objectives for either themselves or their staff/teams, but if you haven't yet got the experience, then, you'll need to invest some time to learn about this before continuing, and seek the counsel of someone more experienced.

Suffice to say that whilst SMART is a good and necessary characteristics, when it comes to the business of trading, SMART is still insufficient for most traders to set good trading objectives.

Good Objectives goes beyond result-based and also covers process-based objectives

This is where most smart professionals (like actuaries, doctors, engineers, accountants, etc.) becomes confused.   In the business, professional, or sporting arena, most objectives are results oriented.  The process part is assumed knowledge and is often taken for granted - the false reasoning goes:  "what good is there to focus on processes when there are no results?"

However, experienced traders will soon realize that if they don't focus on the controllable processes (those that are entirely within their control), but tries to control the unpredictable results from the market (which is by nature outside their control), the outcome is inevitably futile over the longer term.   The market simply doesn't care whether you have a SMART objective or not.  You must appreciate the difference between controllable trading processes, vs, uncontrollable trading results when defining your objectives.

Good Objectives provide a clear framework for your daily tasks

From personal experience, too many of my past numerous attempts at setting objectives for trading failed, because I did not have the "right links" between my clearly painted targets, and what I do as a Trader every day ... there is no "bridge" and so there is no "congruency".  I short, I did not know if what I do on a daily basis will cause me to meet my objective by year end.   Despite being SMART and having it in writing, it is really no different than a mere "wish" or a "dream".

The challenge in the business of trading is that unfortunately markets are extremely good at confusing the average trader.   For example, you may not realize that you are actually doing the wrong things, and yet, markets may reward you for it temporarily in the short term, only to take more away from you over the long term.   Conversely, you may be doing the right things, but over the short term, markets may cause you to lose money, and most traders when measuring their short term performance against their objective may incorrectly come to the wrong conclusion.

In short, just painting a very clear picture of the target and measuring short term performance against it religiously is clearly insufficient.  The trader still needs to ensure that their regular/daily trading activities are defined well enough so that their daily behaviour is consistent and will ensure that they meet their objectives over the longer term.

Breaking down a 5 year objective down into yearly and monthly goals is still insufficient

There is a lot of value to break down a large problem into many smaller problems.  5 year objectives should be broken down into yearly targets and further broken down into Monthly targets.  It will paint a realistic assessment on how much earnings you need to make each month approximately.   But just having this understanding is still insufficient in setting the right objectives.

A good trading objective is similar to a good insurance business objective

As I mentioned previously, the business of trading shares many similar characteristics to the business of insurance and casinos, because the outcome of all 3 businesses at the individual level is essentially unpredictable. 

Fortunately, in my previous life, I have been involved in the insurance business for over 2 decades, more specifically, as the Chief Actuary working in 3 different companies in 3 different countries over the last decade.   Over this period, my responsibilities include significant and major participation and involvement in the company's yearly Strategic Plan, which itself is typically a 4 months process that takes a lot of company resources and senior management time.  As part of my work, I needed to have very clear views from the top down to the key functional levels so that we (together with the CEO and CFO) not only end up with a great Business Plan, but can also defend the Plan from rigorous Head Office senior management questioning in formal challenge sessions.   In addition, personally as a Division and Department Head, I had to set objectives for my own teams.   The objectives are not set and forgotten - as part of senior management, we have regular meetings to monitor the key areas of our company on a regular basis (daily, weekly, monthly, quarterly, yearly).   Once approved, as a Department Head, my objective like every other Department is finally cascaded downwards, and my responsibilities includes monitoring Actual results against Plan regularly, making adjustments as necessary.   As a key member of the Finance team who also meets regularly, I also help my CFO to monitor the progress of the company and the financials of the key functional areas.   The 2 different companies I worked for at the time was the best in their class - AIA in Asia and AXA globally.   At the time, AIA was the most successful life insurer in Asia.  And AXA was the largest global insurer in the world, also most successful by many measures.  Both companies did not achieve success by pure luck alone.

Having lived through this process daily for nearly 2 decades, I can assure you that the 2 businesses I worked for treat their objective setting and monitoring very seriously.  

Everyone in the company have a lot of priorities every day.   We know we did not have sufficient resources to do everything.  Consequently, we must prioritize our activities every day.   The criteria used most often to filter out the unnecessary work and projects are "How is this going to meet my own and company objective for year end?"  Otherwise, the managers know that they will not meet their objectives, and this will impact their year end bonuses at the very least, and they will not give their full cooperation.   Senior management always look favourably to individuals and teams that best help the company to achieve their overall objective.

I would contend that it is the "same thing" with trading (although on a much smaller scale).

The trading business actually comprise of different functions, just like the big insurance companies.   I have come to realize that each of these separate functions in trading needs to have its own objectives - functional / process based ones that are SMART in its own right.   And the trader, wearing his CEO and CFO hat, will then needs to ensure that all these functions, when put together, will deliver the overall trading objective.

It sounds complicated, but it is not.  This is because the business of trading only involves 1 person, and many functions can be done in split seconds.  Trading does not need to involve hundreds or thousands of different individuals.   I have found it much easier to set and monitor my own trading objectives, than helping my CEO and CFO defend the country's Strategic Plan and objectives in large committee formal challenge sessions with Head Office!

A real Life Example of a Trading Objective

The following is an example of a highly simplistic real life trading objective.   My own real life trading objective is much more detailed than below.  I have chosen Option Credit Spreads instead of Stock, because this is what I trade.  I have chosen a real life example, as I don't believe in talking only about "theory" - there are far too many people in this world who can "talk", but I have always looked at the "successful doers" favourably as my role models, the ones who have the track record and showed me their real life account because they have done it, compared to the "talkers". 

The choice of instrument is not so critical, because in both options and stocks, the nature of both are still very similar to the insurance business.  My goal is simply to illustrate the structure of the objectives, and how a large uncontrollable objective result can be broken down into smaller, controllable objectives that are within the trader's full control.  My objective is regularly reviewed from time to time and may be revised without notice.  Treat this as merely an example for your own personal understanding.

S&P500 Sample Credit Spread Trading Objectives

1. Introduction and Scope
S&P500 Option Credit Spreads only.
Options on /ES, SPX, SPY, UPRO, VIX, VXX
Out of scope:   Options on other indices (e.g. Nasdaq) or individual stocks.

2. Objectives
To earn at least 30% returns per year from this Trading System.
This is broadly equivalent to earning 2.5% per month returns.
Over 5 years, this is equivalent to 340% returns.
For every $100,000 invested (insert your own capital size to make it more realistic), I can expect to earn approximately $2,500 per month, which is equivalent to $34k a year, or $340k after 5 years - for the compound interest table, please see here.

3. The Strategy
We plan to achieve 2.5% per month returns as follows:
40% capital invested x 8% ROC per month x 0.8R Trade Expectancy
= 40% x 8% x 0.8
= 2.56% capital per month.

In addition, the 0.8R Trade expectancy can be achieved from a 90% win rate, with a RRR of 1 times, i.e. 90% x 1R - 10% x 1R = 0.8R.   Note that this Plan has factored in expected losses.

4. Trade Expectancy Objectives (The SAFETY objective)
In an insurance company, this function is equivalent to the combined functions of Actuarial, Risk Management, Underwriting and Claims Management, and so, it needs to be broken down into more detail.

We noted the achievement of the 2.5% per month returns is highly dependent upon the achievement of the 0.8R Trade Expectancy.

In turn, the achievement of the 0.8R trade expectancy is highly dependent on the achievement of 90% win rate and limiting losses to 1R.

As we drill down, the achievement of the 90% win rate is highly dependent upon the timing of when the credit spread is sold, and selection of the appropriate credit spread instruments (strikes, expiry dates) sold.  

As we drill into more detail, the exact timing of when the credit spreads is sol can only be done when the trader believes that the market has met the following conditions.  

4.1. Timing the Entry (must meet Underwriting criteria)
In general, a credit spread is allowed to be opened only when the market has satisfy the following (underwriting) criteria:   The trader believes that the market has either "topped" or "bottomed" within the swing time-frame.  The general trading strategy is "Buy the Dips" and "Sell the Rallies".

At market top, we are only permitted to Sell the Rally (Bear Call Spreads).   A market top must exhibit the following characteristics.   First, the S&P500 index must be at the top or near the major resistance levels that have been preidentified.   It is not just any resistance, but a "strong" one.   There must be a confluence of resistance that makes it "stronger" and therefore, more likely to hold.   At the very least, there must be a confluence and a majority of momentum indicators that shows that the upward momentum is more likely to be exhausted / temporarily stalled, than not.  

Conversely, the bottom must also exhibit the converse characteristics above.

As no one can precisely pick tops and bottoms consistently, a "scale in" approach is permitted, with the bulk of the selling happening at the top or just after the top is seen at smaller timeframes, with the overall broader time-frames indicating with very high probability that that is the "swing top".

(The specific conditions should be fleshed out in detail, in writing.  It is beyond the scope of this article to cover it in full, but this blog contains many articles that can be useful).

4.2. Selecting the Right Option Strikes and Expiry (must meet Underwriting, Actuarial and Risk Management criteria)

In general, we must select the right options (strikes, expiry date) so as to deliver the 90% win rate.  

This is broadly similar to the Underwriting, Actuarial and Risk Management functions combined in the insurance company that ensures "safety" in the insurance/trading operations when new policies/new trades are opened.

At the "swing top", we select options where the Option Chain table indicated that the probability of becoming ITM is 5%-8% per month.  This suggests that we may have a win rate of 92%-95%, which should meet the 90% win rate requirement above.   In reality, we expect higher win rates than those indicated by the Option Chain pricing table because of our strict Entry Timing criteria.   When sold at the right time, there is usually a large Margin of Safety / Buffer, from where the index is, to the point when we would only start to lose.

4.3. Risk Management to keep losses to 1R (similar to Claims, Actuarial & Risk Management function)
Keeping losses to 1R at the most is a critical function, to ensure that we meet the Trade Expectancy of 0.8R, and thereby, meet the achievement of our overall 2.5% returns per month.

In more detail, if we write credit spreads with say 5% PITM (Probability ITM), then, our guideline requires us to start taking hedging actions when price has proven us wrong and the PITM starts to exceed 10%-20%, depending on our own chart readings. 

As an option trader, our option to "cut loss" is much wider than stock traders.   We can choose from many alternatives, such as the standard cut loss (like a stock trader), but that would cause a loss in income.   As a result, we need to find other ways to make up the "lost income".   Some of the ways to make up the lost income can be to "go out further" (to make it safer, say half the PITM), to go to the "other side" (with also half the PITM), to go to a longer DTE or to choose another instrument.   In short, we plan to make "ourselves whole again", so as to meet our objectives.   Other hedging methods include just adjusting the Sell Option leg, leaving the Buy Option leg intact.   Alternative hedging methods including Buying an ATM Put or Call so as to zeroize the directional / Delta (and reduce gamma) risk, to temporarily focus on the Theta decay from the entire Option structure.   A full discussion of the hedging methods are outside the scope of this article (but should be fleshed out in writing, so as to make the Claims Management function extremely clear).

If we fail to make ourselves "whole again", then, we will accept less or zero income, which is still not a loss.  In the absolute worst case scenario, we accept losses up to  1R, and performed no worse than planned.   This will ensure that we keep losses to 1R, to enable the broader Trade Expectancy objectives of 0.8R to be achieved, to ensure that overall, we meet our trading objectives of achieving 2.5% per month capital. 

5. 8% ROC per month Objective (The FINANCIAL objective)
This is a critical component to the overall objective.  The achievement of a minimum ROC of 8% per trade per month drives directly the achievement of the overall trading objective to return 2.5% capital per month.

Of course, markets are not always cooperative.   We may not always achieve 8% with 30 DTE at the swing top/bottom (particularly if it was not a significant swing).  However, the 8% figure is conservative.   So far, it is relatively easy to achieve, in fact, in YTD 2015, we have achieved significantly more than 8% per month.  

However, market volatility is not constant but is dynamic and frequently changes over time.   It is expected that eventually, market volatility will swing from high to low, and ROC depressed.  Under these conditions, we may have to go to a  shorter duration to find higher yield - for example, it is quite common to find 6% returns for 14-21 DTE when 30 DTE shows 8%.  This approach is also acceptable, since it is broadly equivalent to 8% for 30DTE ROC.  

Conversely, sometimes, we may find situations where market provides approximately 16% ROC for 60 DTE.   Since this is broadly equivalent to 8% ROC for 30DTE, we may also accept this trade to "lock in" the ROC that meets our objectives.

6. 40% capital invested Objective (The Sales objective)
This is also a critical component to the achievement of the overall objective.   It is similar to the concept of "volume" or "revenue" and so, is similar to the Sales function in an insurance company.  In other words, if the Head of Sales fail to meet the required sales quota, then, the company overall objective will be adversely impacted.   In our case here, 40% capital is the Sales quota.

So, when the right market conditions are met and the Underwriters have approved the market conditions, the Head of Sales must not hesitate to sell credit spreads.   He must act promptly, because often, the "window of opportunity" will only last for a very short time, as markets do not stay at the "top" or "bottom" for very long.  

If the Head of Sales fail to invests up to 40% of his capital on Credit Spreads, he will fail to meet the 2.5% per month objective.   The sales function is entirely within the CEO Trader's control.

Note that this objective is flexible enough so that if in a week, only 30% capital is utilized, then, in the second week, when market provides the opportunity, he can "make it up" by utilizing 50% of capital so that on average, 40% capital is utilized in that month.  It is also flexible enough so that if in a month, only 30% capital is utilized, the following month can utilize 50% so as to average 40% over 2 months.   And so on.  

(the full objective is much longer, as there are psychological functions that are similar to the insurance company functions such as the Valuation/Actuarial function, etc.   A full discussion is well beyond the scope of this article).

7. Dynamic objectives
It is my article's contention, that when all functions of the Trader meet its objectives, then, the overall trading objective of 2.5% capital is met.
However, market conditions are rarely fixed, but dynamic.  The market is comprised of highly intelligent market participants that could potentially change market dynamics in the future. 
Fortunately, the plan is adaptive.   If market volatility somehow becomes lower that makes the achievement of 8% ROC per trade per month extremely difficult, then, the 2.5% can still be achieved by increasing the sales quota, for example, from 40% to 50% capital.
Therefore, there is tolerance and some flexibility in the sub-objectives, to meet the overall objective of 2.5% capital per month.

Implications of the Trading Objective for the Trader Daily Operations

As you can see from the highly simplified sample objective above, I have taken an overall objective of 2.5% return on capital per month, and then proceed to break it down in more detail according to the many different functions of the trader.  

Each function of the trader has its own clearly specified objectives.

Furthermore, each functional objective is specified in such a way so as to be directly under the control of the trader.  We will only act when those specified conditions exist, just like an insurance company will only accept risks when clear conditions are met.

It is my strong belief, that if every function of the trader meets its objective, then, the overall Trader objectives will be met.   Mathematically, we know this to be a certainty.

Hence, the primary risk of not meeting the objectives of 2.5% capital return per month for the trader over the long term is when his own practice has deviated from his Daily Operating Guide and his Objectives.

He will not meet his objective, if the Sales function doesn't perform (the 40% capital utilized on average). 

He will not meet his objective, if the Underwriting function doesn't perform to time the sales near market tops/bottoms.

He will not meet his objective, if the Claims/Risk Management function doesn't perform to keep his losses to 1R or less.  And so on.

In other words, what the Trader does and all his different "parts" in him, must be "congruent" with the overall Trading objective, and the individual parts of that objective.

It is only when all parts are "congruent", that the Trader will then meet his overall objective.

Three more things

1. As you can see from the above, the trading task is actually a "complex" task that can be broken down into many "parts".  Failure to recognize each of these separate parts is likely to lead to an overall trading failure.  Whilst I have illustrated the different "functional parts" of the trader, there are also the different "psychological parts" of the trader that needs to be acknowledged.   In effect, the trader actually comprises of a "board" or a "committee" of different parts that works together to achieve the overall business objective.  Failure to recognize the different psychological parts is also likely to lead to failure in meeting the trading objectives over the long term.

2. As you can see from the above, trading is not a "hobby".   It is a serious business endeavour, just like an insurance company business.   A trader who doesn't acknowledge his business as having different parts, and do not have SMART objectives set for each of these different parts is not likely to meet its final objectives over the long term.  Having objectives set for each of the different parts will enable the CEO trader to then monitor the progress of the different objectives, and then take the necessary "corrective" actions, so as to achieve the overall (old or revised) objective.

3. Bear in mind that the above sample trading objective is far from complete.  For example, I have not yet describe what to do in a catastrophic event like a "Black Swan" event like 911.   On this fateful day, markets were closed for a week, and when they re-opened, markets immediately crashed down.  The size of the crash is larger than most option credit spreads can cater for, and is likely to result in temporary maximum loss - very likely, the loss will approach the 40% capital allocated.  During this situation, the Trader must also know exactly what to do so as to come out at a profit.   This requires the Trader to kick in a different trading system that will take advantage of this extreme event.  A full description is outside the scope of this article.  Suffice to say that there is no one single system that will deliver profitability all the time.  Different systems works better under different market conditions, and the trader must exercise his CEO function to choose the right system at the right market conditions.  If the trader does not exercise his CEO function, his business will fail to meet its business objective.

Wishing you all the best in your trading business!