What are the three key components to running a business? If you had to determine what the most important part of running a business was, what would it be? Lets look at an article from Business Insider based on one of my favorite TV shows, Shark Tank, regarding the 8 most commonly asked questions on the show. Click the pic below and read the article and then we will talk more.
Get it? They are all awesome questions for sure but I want to focus on one of them today:
This is probably 4 years of Harvard Business School wrapped into one sentence. Let me summarize it again just in case you missed it. The three basic points of running a business:
1 COST- What it costs you to make each product or service
2 PROFIT MARGIN- The difference between the that cost and the unit sales price
3 MODELING- Prepare to outline overhead costs and I would add to that projected sales and profits
This is how you run a business. This is how you get others to invest in your business. Plain and simple right?
So why don’t we as traders adhere to these principles? Are we gamblers and not business owners? Maybe, but even gamblers have set limits on losses or #1 from above, they know what each pull of a slot machine or hand of cards will cost them. Traders have all the opportunity in the world to change that variable on a real time basis. We can move stops, run no stops, or trade too big and create an environment where loss or cost will be too much of the P&L and profits are meaningless.
Let me give you an example. A store buys a couch to put on its show room floor. Lets answer the three questions from above.
Cost of acquisition- what did it cost the store to obtain that couch? $125
Expected Sale Price- $450 (450-125= $325 in gross profit margin)
Model- “I believe we can sell 10 couches per month grossing $3250”
Let’s say for a minute that you purchased the couch for the $125 but realized that it needed other pieces or needed some kind of work done before you could sell it. So on top of the $125, $150 in refurbishments were required. What is the cost of the couch now? $275. You can still only sell it for $450 so now the GP is only $175. This scenario then in turn throws off your ability to model. Now imagine that all 10 of the couched you plan to turn this month will have variable costs associated with them. Modeling is all but useless.
Inventory needs to have a fixed cost. It should not be a lever that you manipulate to run the business. Find a manufacturer or a supplier, negotiate that cost, and then run your business accordingly. The more variables we can eliminate, the better off we will be.
How does this relate to trading?
We must have a fixed acquisition cost associated with every trade. I’m not talking about broker fees/commissions. I’m talking about what’s the worst case scenario that could happen to your product. If it fell of the shelf and broke, what are you out? I want to run my trading as a business, so I need to manage my costs. If I have a $10,000 account, and I fix my cost at $100, I am giving myself a great chance of survival. If I fix my cost at $1,000 then I am making every trade and every piece of inventory much to important and risky. Control the costs so that profit margins are available.
One quick word about profit margins, there have to be some! If I purchase the couch at $125 and then turn and sell it at $125, what are the margins? $0. If the cost is $125 and I sell it for $200, then it’s a $75 or 50% margin. Not bad. But the main takeaway is that it can be modeled.
Again, how does that relate to trading? If I risk $100 on a trade and make $100, then my margins are effectively 0. We could discuss win rates and such right now but win rates fluctuate so much that a business could never operate under that premise. If selling couches relied on win rate and not fixed up front cost, the business would fail. Lets keep thinking of our trading account as a business that has a fixed cost, a profit margin, and as such can be modeled.
This is a bit of rambling but I hope the point gets across. If you haven’t already, start running your trading like you would run a business. It’s vital to your trading success.
The Trading Business is a great business. Treat it like one.