You May Be Understating Your Paper Profits. Here’s Why…

Businessman analyzing investment charts at his workplace
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When does a paper profit become a real profit?

Some people like to see money in the bank. Only then will they chalk up a trade as a win.

Others take a more liberal approach. These people don’t need figures on a bank statement. It’s a case of tallying the gains as they go. For them, a paper profit is every bit the real thing.

Think about it for a moment. Which of these best describes you?

If you’re like me, you may do a bit of both. It all depends on the situation. The key is to know when to think one way instead of the other.

Let me tell you about a friend of mine. His story is a classic tale of when money in the bank means everything. There are times when you just can’t rely on paper profits.

A paper profit mirage

The year was 1999. My friend, Sean, was a bond trader at a global investment back. He also traded his personal account with great success.

Sean was what we call a contrarian trader. His strategy was to look for extremes in either optimism or pessimism. He would then trade in the opposite direction.

One of the most out of favour markets of the time was gold. You see, the precious metal was in a bear market. Central banks and hedge funds were constant sellers. The miners were even selling gold they were yet to mine. It was a full on bust.

This was exactly the sort of set-up Sean would target. It was a textbook contrarian play. Almost no one thought gold could go higher.

Sean decided to trade gold via the options market. He bought a deep out of the money option to buy gold in six months. This meant gold had to rally a long way for the trade to be profitable.

The high exercise price was part of Sean’s strategy. This gave him a lot of leverage. It was a bit like backing a longshot to win. Even a small bet will give a big payout.

I remember Sean saying the option cost him around $40,000. The outlay was relatively small compared to the potential return, but it was still a big personal speculation.

Well, Sean was right. Gold exploded higher. It erased two years of losses in just 11 days. This was one of the biggest reversals ever seen in the precious metals market.

On paper, Sean’s profits were staggering. He was up over $1 million. It was the fastest trip to millionaire status I’ve ever seen.

Sean went to close the trade. He’d put it on via the options desk at the bank where he worked, so he wasn’t expecting a problem. But there was one. You see, the ownership of the bank had changed. And management wasn’t keen on personal trades. Sean couldn’t get out.

Management eventually relented. But the delay was costly. A sharp correction washed away the lion’s share of his profit. Sean ended up pocketing about $250,000 — a lot of money, but well short of a million dollars.

Sean’s paper profit was anything but money in the bank — it was mostly a mirage. He could see it, but he couldn’t touch it.

The dotcom millionaires had a similar experience. On paper, they were worth a fortune. But their shares where often held in escrow. This meant they couldn’t sell. Worse still, some borrowed heavily against their paper wealth.

Many of these new millionaires lost everything in the crash. While their paper profits were gone, the debts of a big lifestyle remained. Spending paper profits is the worst thing you can do — especially when you can’t sell.

The better half

So when should you consider a paper profit as real?

Well, I use a simple test. There must be a high expectation that I will be able to exit at a fair price. If an asset passes this test, then I’m comfortable counting a paper profit as real wealth.

I know many people don’t think this way. Instead, they put their paper profits to the side. They believe a profit doesn’t count until it’s in the bank. Have a read of the following email…

It is getting close to one year of live Quant Trader signals, and I note as follows:-

  • 150 long trades have been closed
  • Only 47 trades have been profitable — about 1:3
  • 174 trades remain open
  • The closed positions show a loss of $5,818 (assuming $1,000 per trade)

 My trading philosophy accepts that only 1 in 3 trades are successful BUT by running profits and cutting losses, the profits from those 1’s should exceed the accumulated losses from the other two. Quant has not achieved this yet.

I was always taught that a profit is not a profit until the cash is in the bank so, having regard to the facts stated above, how many years do you expect it will take before cash from closed positions exceed (losses + cost of funds + cost of subscription)?

Member, Alan

Alan is correct. From a money in the bank standpoint, Quant Trader’s signals are losing money.

But I don’t think this is the correct way to assess a stock portfolio. It ignores the profits and losses from open trades. You don’t get the full picture without these.

Take my personal portfolio for instance. I revalue it regularly. This tells me how much I would receive if I sold every stock on that day.

Yes it’s a paper profit, but it is realisable profit — I can quickly turn it to cash. This is the key difference to Sean and the dotcom millionaires.

With this in mind, let me show you the stats for Quant Trader’s 174 open long trades…

    • 113 are profitable — that’s 65%
    • The hypothetical profit is $31,200 (assuming $1,000 per trade)

The results for open trades are entirely different to closed trades. You could easily think they were for different systems.

The reason for the variation is simple. Quant Trader runs winners and cuts losses. This means closed positions will initially have a losing bias. The best stocks could remain open for years. Counting closed trades only will distort the true picture.

Now, I would never suggest spending an open profit — that’s a sure way to get into trouble. I avoid this by keeping separate accounts. My trading capital and everyday money never mix.

But my open profits and losses, although unrealised, are every bit as real. I believe it’s a mistake not counting these simply because they’re on paper.

My approach to accounting for profits and losses is simple. I value an asset at its current selling price. As long as there is a ready market, then the profit is real.

Until next week,
Jason McIntosh,
Editor, Quant Trader

 

Publisher’s note: If you are concerned about the recent market volatility, here’s one thing you should do. Check out Jason McIntosh’s Quant Trader advisory service. It’s a fully algorithmic trading system for ASX stocks. Quant Trader scans practically every company. I can just about guarantee you’ve never heard of many of these unique ideas.

If you’re not familiar with Jason, he was a trader at one of the world’s most powerful investment banks for nearly a decade. He’s seen dozens of market corrections and crashes. This experience is hard coded into Quant Trader’s algorithms. And the results speak for themselves.

So if you are at all worried about the markets…if you’re not sure when to buy or sell…I strongly suggest you looking into Quant Trader now.

Try it. See if it makes sense to you. It could change the way you trade forever.

Jason McIntosh,
Editor, Quant Trader

Publisher’s note: If you are concerned about the recent market volatility, here’s one thing you should do. Check out Jason McIntosh’s Quant Trader advisory service. It’s a fully algorithmic trading system for ASX stocks. Quant Trader scans practically every company. I can just about guarantee you’ve never heard of many of these unique ideas.

If you’re not familiar with Jason, he was a trader at one of the world’s most powerful investment banks for nearly a decade. He’s seen dozens of market corrections and crashes. This experience is hard coded into Quant Trader’s algorithms. And the results speak for themselves.

So if you are at all worried about the markets…if you’re not sure when to buy or sell…I strongly suggest you looking into Quant Trader now. 

Try it. See if it makes sense to you. It could change the way you trade forever.

Jason McIntosh

Jason McIntosh

Jason is a professional quantitative analyst. Before he graduated in 1991 he joined Bankers Trust — a Wall Street investment bank — to be a trader. After Bankers Trust was taken over in 1999, Jason, already financially independent, co-founded a stock market advisory and funds management business called Fat Prophets. At 37 he sold his part of that business and retired. These days, he’s a private trader and system developer. In 2014 he launched the wildly successful trading service: Quant Trader.
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