How much do traders make?

The Liquidity Cap : Why day traders are capped on how much they can make

Disclaimer : although there are some trading techniques and rules detailed in this post, this post does not endorse nor does it educate the reader to any applicable extent to trade. I am not a financial advisor, nor am I giving financial advice, the following article is written based on my own understanding on the topic.

There’s a common misconception when someone first starts learning to day trade the stock market. The general idea is that the more money you have in your trading balance, the more you can potentially earn from trading. While this is true for balances up to around $50,000, the relationship between balance and potential trade return becomes less and less linear beyond this point. In fact, there’s a diminishing marginal return on trades that use more than this amount of capital when day trading.

To explain this reasoning further, we need to first model trading outcomes based on how experienced day traders will trade. While different traders have different rules and different methods of trading; most traders have some rules in common which they follow which are:

1. Never risk more than 1% of your capital on a single trade
2. Make sure your upside is at least 2 times higher than your downside

Rule #1 makes sure that no one trade will cause detrimental damage to your portfolio and future returns, whereas Rule #2 makes sure that in the long term you’re most likely to profit. With these two rules, we have enough information to create the trading returns model that most people are familiar with.

The incomplete trading returns model

With the above rules, we can make some assumptions and begin to demonstrate how much a day trader can make. Let’s take an average experienced day trader who can find and execute on 5 trades per day which go to either stop loss* or take profit**. Let’s assume that for rule number 1, the trader uses a 1% risk cap so per trade he puts a stop loss of 1%. Using rule #2 we know he’ll put his take profit at 2%. Let’s assume, he profits on his trades 40% of the time. This means per day he will make

5 x [(40% x +2%) + (60% x -1%)] =

5 x [(0.4 x +0.02) + (0.6 x -0.01)]

= 1% a day

• * stop loss order : an order to automatically sell the trading position if the price falls to a certain level — rule#1 this makes sure that risk is maximum 1%
• ** Take Profit Order : an order to automatically sell the trading position if the price rises to a certain level — rule#2 this makes sure that the profit is secured at at least 2 times more than the potential loss.

Now this is where the misconception comes in, this seems like trading is infinitely scalable. Theoretically it seems that you can even make $1million a day if you had $100million in your trading account… This is far from true. In fact, this model only works consistently for traders who only use $50,000 per trade, which means the maximum they can make consistently using this model is actually only $500 a day. ~ Of course, a trader who is more experienced at finding trading opportunities, and has a higher probability of profiting per trade will make more. However, this is still usually capped at around 2% ($1,000) a day. To understand why this cap is present, we need to understand something called volume first.

Volume

The volume of a stock is simply the amount of shares traded in a certain time period. For example: If Stock XYZ had a volume of 650,000 yesterday. This means that 650,000 shares of stock XYZ were traded yesterday. Volume can also be shown on other time scales other than daily; it can be shown on a volume per 4 hours, 1 hour, 30 minutes, 5 minutes, 1 minute … any practical timescale really.

Volume can be used to create other indicators; Relative volume is the volume of a stock in one time period compared to another. Relative volume is calculated using average volume. For example : if the volume of stock XYZ is on average 650,000 and today it is 975,000, the relative volume would be 1.5 (975,000 divided by 650,000).

Now we can introduce another rule day traders like to follow:

3. Only trade “in play” stocks

A stock which classifies under “stocks in play” are stocks with a fundamental catalyst — a piece of news that makes the stock move, a relative volume of at least 1.5 and a stock which has at least an average daily volume of 500,000 — this is to make sure there’s enough extra interest to create greater movements than normal, these aren’t the only properties a stock needs to have to day trade but these are all we need to show how much a trader could potentially make.

Liquidity

In the stock market, liquidity refers to the ability to sell your shares with ease at market price. To demonstrate this idea, let’s say you currently own 1 share of stock XYZ and it has average volume per day of 650,000, it’ll be very easy for you to sell that 1 share at market price as there will probably also be someone trying to buy some shares at market price. However an issue occurs if you’re trying to sell a large amount of shares at once. If instead of 1 share, you have 100,000 shares you wish to sell, you most likely won’t be able to sell it at market price.

It’s very unlikely that with a daily trading volume of 650,000, at any one moment there is enough interest to buy 100,000 shares at current market price. In general, traders like to stick to only entering trades buying a maximum of 5% of the daily volume amount in dollars as this makes getting out the trade near instant — this means if the daily volume is 650,000 shares, the maximum trade size should be $32,500 (650,000 x 0.05 = $32,500). This is the general rule for medium float stocks — stocks in the $10-$100 price range.

If a trader doesn’t do this, they’ll only be able to sell a portion of their position at their take profit level and risk having to sell the rest at a lower price which will impact the long term effectiveness and profitability of a trader. Trading larger positions is more suited to traders who trade longer periods of time, not day traders, as they can formulate a plan to close their positions bit by bit.

It is this liquidity cap that stops the linear relationship between trade size and returns when trade size exceeds 5% of the average volume of a stock.

How much can day traders actually make then?

If we take the incomplete model which suggested that a trader will make around 1% a day. Since the stocks that should be traded should have at least a volume of 500,000, a trader should only use $25,000 per position. That 1% tends to be $250 for trading stocks of minimum average volume. In practice, the stocks traded will have a volume much greater than 500,000 — more like 1,000,000 so the average experienced trader could expect to make $500 a day with $50,000 per trade that reaches the one million average volume mark. Anything beyond that will cause the trader to run into liquidity issues. This also doesn’t take into account any extra fees or charges incurred by opening and closing trades.

Short Answer

An average experienced profitable trader can expect to earn 1% of portfolio size a day which doesn’t scale well passed a portfolio size of $50,000 — therefore around $500 on the higher end… minus trading fees.