The concept of the OC is central to life’s decisions. I tend to focus on it when I refer back to my road-map. It also plays a central role when I contemplate the long-run viability of trading as a career. I am not talking about the television series, but about ‘opportunity cost’, a central concept in economic theory.
The Library of Economics and Liberty says of opportunity cost:
When economists refer to the “opportunity cost” of a resource, they mean the value of the next-highest-valued alternative use of that resource. If, for example, you spend time and money going to a movie, you cannot spend that time at home reading a book, and you can’t spend the money on something else.
It’s a slightly more abstract way about thinking about the costs of choices, but the concept of ‘the next best alternative’ is a very powerful idea. Say, for example, I decide to spend £100 on an MP3 player. The question is ‘what else could I have done with that £100?’. For sure, I wouldn’t have bought the MP3 player if could have bought something for £100 or less, that I knew would have brought me greater satisfaction. So, what else could I have done with the money? I could have: bought a Play Station off E-bay, gone on a weekend holiday, bought some new clothes, or I could even have saved the money, or invested it. The list is endless, but I am only concerned with the next best alternative, say the weekend holiday, and that is considered the actual cost of the MP3 player, because it is what I would be truly giving up to get it.
The concept of opportunity cost can be applied to trading decisions, and to the decision to be a trader itself. For example, when I trade I am operating with limited capital and I must try to find the most profitable opportunities. If I take a trade with a low expected pay-out, I am losing the opportunity to use that capital in a trade with a high expected payout. It is not certain that the high-value opportunity will present itself during the session, but if it does, the risk is that this portion of capital is either tied up in a low value trade or that it has disappeared entirely as a trading loss. In my case, I am learning to severely limit any trades outside my main trading strategy. Within the strategy, I am constantly trying to trade in a size that relates to the perceived opportunity. I believe that asking what you are giving up, each and every time you consider placing a trade, is essential to the trading process.
And what of applying opportunity cost to the decision of being a trader? Here is a rough and ready approximation of my expenditures over the past two years:
Brett Steenbarger says of successful trading:
… my definition of a competent trader is one who is consistently able to cover his or her costs. To cover one’s trading overhead actually requires a high degree of profitability, and most traders can’t do that.
Regardless of the gross profits of my trading activity, I cannot cover my costs, which amount to approximately £15,700 over two years of trading. I’ll admit I have included a lot of general spending (holidays etc) in my costs, but this represents a relatively frugal existence and I need to be able to cover this ‘base expenditure’ at the very least. However, my net position is down some £5.5k since I started trading, suggesting I am failing even to tread water. However, during this time, I have been able to pursue my dream of working for myself and really pitting myself against the markets. I have been my own taskmaster, operating off my own discipline and motivation. It has also been a great learning experience. I value this highly.
However, the opportunity cost of this experience is immense. I gave up up a well-paid job with excellent prospects, to trade full-time. However, I’d had enough of that job and would have left anyway. So, what was the next best alternative? There certainly were plenty of jobs I could have tried, jobs that could have been less financially rewarding but more emotionally satisfying. I could have taken my money and gone straight to a prop house and tried my hand there. The sacrifice of time also has to be factored in to one’s thinking, and in this time I could have studied for a Masters in philosophy. In terms of rankings, the course of action would likely have to have goe to a prop house first, then tried other jobs, and then the study of philosophy. Another cost I am starting to appreciate is that the longer we spend out of the employment game, the harder it is to get back in. Despite age discrimination laws, this is a hard fact of society.
Thus, it is not the explicit financial loss I have suffered (£5.5k) that mark the true cost of this endeavour, but the sacrifices made. I have no regrets, but I know that would not be the case if I found myself in the same position a year from now.