Background
Savvy investors will determine the total cost structure before making an investment decision. While historical returns and membership price are important factors in estimating investment returns, it is important to factor in all costs to make an educated decision. This brief tutorial describes one way to financially analyze a trading system.
Formula to calculate return after fees
The formula to analyze an investment decision is simple but you must identify and sometimes assume several factors. The formula to calculate annual return after fees is:
- r = p - (a + s * n) / i
- if r > c then trading system returns exceed opportunity costs
- if r < c then trading system returns are less than opportunity costs
- c - Opportunity cost of money (% / year)
Opportunity cost is the general consensus "market" return. You may already know this because all of your investments averaged XYZ% annually over the past ten years. Investing in a new trading system means removing the opportunity to invest in your old, tried and true investments. Many people benchmark against a long SP500 position as we do here. Generally, if your investment return exceeds a long SP500 position, then you are "beating the market" according to many investors. - i - Initial investment ($)
Most trading systems assume $10k initial. Higher initial capital decreases the percentage loss from commissions and fees. - s - Broker commission for one trade ($/trade)
Check with your broker for commission fees. If your trading system uses options, you will have to factor in per-contract fees into your commission totals. - n - Trades filled annually by service (# trades/year)
This is one of the largest hidden costs of trading systems. Most trading systems quote historical returns before commissions, as if we lived in a commission free world. Ask your provider to estimate trades per year. Remember, you will need to account for both buys and sells but may ignore options that expire worthless (if your system uses options). - a - Annual membership fee for the trading system ($/year)
Get a fee estimate from your provider. If you plan to use a monthly plan, multiply by twelve to make an annualized value. - p - Estimated annual return by the trading system, before fees (% / year)
This is another fuzzy number where you will have to make an assumption. As with all trading systems, past performance is no guarantee of future perormance. Never believe trading system performance at face value - many trading system websites literally quote misleading and false numbers. Instead, ask for their prior positions and calculate returns yourself. You might be suprised at what you find. - r - Calculated annual return by the trading system, after fees (% / year)
This value is calculated from the estimates and assumptions above.
Example scenario
Below is an example using typical values from Zig Zag North. IMPORTANT: We cannot guarantee the returns, number of trades, fees or any other estimates quoted below (see disclaimer).
- c = 9.0% / year --- approximate long SP500 annual return from 1988 to 2008
- i = $10,000
- s = $9.95 / trade
- n = 14 trades / year (e.g., seven switches include both a buy and a sell trade for each)
- a = $399 / year
- p = 18.0% / year
- r = X % / year
And plugging the values into the formula:
- r = 20.0%/year - ($399/year + $9.95/trade * 14 trade/year) / $10,000
- r = 20.0%/year - 5.4%/year
- r = 14.6%/year
In this example, r > c or 12.6%/year > 9.0%/year and the trading system returns are greater than your opportunity cost investment.
Another way to think about financially analyzing a trading system is to simply calculate the trading system fee structure. Calculate the percentage losses due to fees, as we did above (5.4%/year losses). Excess trading system returns over your opportunity cost investment returns (18.0%/year - 9.0%/year = 9.0%/year) must exceed the trading system fee structure (5.4%/year) to maximize returns.
Lastly, it is possible and more accurate to factor taxes into return calculations. The math above assumes zero taxes, which may or may not be realistic. For example, some IRA accounts are not taxed until withdrawal after retirement. If your opportunity cost investments are tax free, i.e. tax free bonds, and your account is taxable then taxes are a significant factor and should be factored into returns.