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Every day I have a crap day at work and a good day in trading I start doing the mental arithmetic about how long before I can quit my day job. In this posting I will look at a topic that has been dear to my heart of late, which is how long till you can quit your job.

How Long Till You Can Quit Your Job?

Unfortunately the answer to that question is not: I will spend 6 months learning to trade and then probably a year from now I can quit my job. Trading for a living requires two things:

• An edge over the market; and
• Sufficient Capital

Estimating how long it will take for you to find an edge unfortunately is not a fixed amount of time. For example, you cannot expect to read a couple of books, go to an expensive seminar, or read forums and blogs and just get an edge. Finding an edge in trading takes a lot of hard work and requires you to have several “AHA” moments where the pieces fall into place for YOU. For some natural traders these pieces come within a matter on months and for others it can take a decade or longer ….. For most of us a couple of important pieces fall into place within the first year, but the last few pieces are elusive, and we go through very long frustrating periods of break even trading and ongoing learning until the last couple of “AHA” moments happen.

Once you have found your edge and you have collected some data through a combination of back testing, forward testing and live trading through a large number of trades in a range of market conditions, you will have a good idea about how good your edge is. It is at this point you have enough data to answer the question about “how much do I need in my trading account?” and therefore “how long before I can be financially free?”.

Tools for Estimating “How Much is Enough?”

In estimating the time to be financially free I like to take your average retirement calculator and modify it for achieving financial freedom through trading. The one I have been playing with of late is a montecarlo based calculator by riskamp (website here and excel spread sheet is available here). The nice thing about riskamp is it allows you to model through hundreds if not thousands of “what if” scenarios. For example, it can be used to tell you what the likely upper range of your outcome would be and the likely lower range of the outcome could be.

Montecarlo based testing requires you to be able to input your average return and your standard deviation in return. In addition to this you need to input into the spread sheet you starting capital, how much of it you are allocating to trading and to cash and how much your living expenses are. I also modified the spread sheet to work on a month by month basis and to include the cost of taxes.

In the following example, we will assume a trader is capable of trading at the same level as a professional (e.g. 60% per annum and a 30% standard deviation or roughly an average of 4% per month return with a 2% standard deviation), they have moderate expenses at around $6000 per month and have a high marginal tax rate of 45% (rather than using these levels you should be using your own stats from your trading results. However, for the purpose of this article we will use the above examples).

So the question remains: how much is enough?

Basically you are going to need around 325,000 in trading capital to be financially free with this kind of track record.

If you could live more frugally and get your family to survive on only $4000 a month, then you can kind of break even on 200,000, but as you see below there is a risk of your account slowly dwindling over time:

The other alternative is to run your account hot and use more leverage. This increases both the return and the variance in returns. For example, if you leveraged your account up 4:1 you could average 16% per month with a 8% variance then you would need only about $75,000 to be financially free, but your risk of ruin is significantly higher. One bad run of trades and you will be going back to the being a wage slave.

As you can see, unless you are a Mr Moneybags already, financial freedom cannot be gained without sufficient capital, cutting your costs, taking greater risks in your trading and perhaps restructuring your tax situation.

If for example, you increased your leverage a little so that you could average 6% return per month, with only a 3% variance in return.  Had 150K in your trading account.  Trimmed your expenses to 5000 a month for the family.  And finally traded inside a company structure which only has a 30% tax rate.  Then you would see financial freedom is somewhat closer.

But I how do I get this much money?

A number of traders I have met at conventions or local trading groups don’t have this problem. Usually they are:

• Old and grey and are trading their retirement funds that they saved over a life time, or
• They inherited it from someone else, or
• They made money after selling some of their rental properties, or
• They have another business that they have made money from.

Unless you are one of these kind of people, you are going to have a different and often more frustrating journey.

The other kind of trader you meet is the frustrated one. You know the ones. They are usually younger and have around $10,000 in their account and financial freedom looks daunting.

If you take this situation then, and use the final scenario depicted above, it will take you around three years to get there (but only if you also scrimp and save and manage to contribute another 1500 to your account each month).

The reality is though for many of us we have only had some of our “AHA” moments, and our trading is far more variable in its outcome.  People don’t save or trim their costs. They quit their jobs too soon.  And people don’t look at their tax situation.  So what we tend to see is this:

Financial freedom as you can see is somewhat of a challenge and is more complex than just a function of time.

The Downside of Estimating Time Till Financial Freedom

Just as a parting thought, I find that when I start day dreaming about financial freedom my trading usually turns to shit. My risk appetite increases because I am desperate to be financially free sooner and the quality of my trading decreases because I am too keen to make trades. The net effect is bigger losses and my vision of financial freedom is set back (or sometimes bought forward through blind luck - but that is a story for another time). So you need to know that that kind of thinking is dangerous. A better way to think is to keep on sticking to the daily grind of compounding your account using high quality trades and then put that extra energy into finding a system that has a better edge and is safer to run with higher leverage.

Next Posting

In my next posting I want to look at tools which will help you analyze your trading results and help you understand your edge a bit better.

This entry was posted on Saturday, September 20th, 2008 at 9:12 pm and is filed under Financial Planning. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.