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Focus: Return on Capitalv

Many, if not all of us have seen advertisements or promotional articles from investment and trading services boasting headlines such as “Recommendation X Up 250%” or “How to turn $1000 into $84,954 in 2 months” as well as captions like “Our Top Ten Trades are up 92%”, but very rarely do any of these newsletter services publish what we view as the single most important figure: Return On Capital (ROC).

In this context the ROC is the percentage return that a subscriber would have received, having invested a certain sum of money in accordance with the trading signals and investment recommendations of the service. To take account of time, the return is often annualised, since a 50% return in a year is better than a 50% return over 10 years. In our opinion, apart from the annualised return on capital, the majority of other statistical claims of performance are just noise and should be ignored.

Let us look at some of these claims. Our examples are not taken word for word from what some services are claiming, but are typical of what we have observed in the industry.

First let us take a look at lines such as “Recommendation X Up 250%”. In the most unscrupulous of cases, this could simply mean that a stock that the service recommended is up 250% from some low point, however the service may not have started recommending that its subscribers buy it until it had already gained a great deal, leaving the real gain from the buy recommendation to date looking far more modest.

Also, if the recommendation is up 250%, has the letter or service given a sell signal? If not then we think that it is misleading to claim such a profit, since closing a trade is just as important as opening a trade, since those paper gains could easily evaporate. Sometimes the letter will still claim the large gain after the recommendation has fallen, even if there has been no sell signal, or if the trade turns negative you will simply never hear of it again, but the initial headline has done its job and lead people to hand over the subscription fee and sign up. At SK OptionTrader, we only publish closed trades from our premium options trading service, SK OptionTrader, never boasting about paper gains that in our view have yet to be banked.

Even if the investment letter or trading service did indeed recommend to buy at a low price and sell at a high price as to produce a fantastic profit of 250%, how much did they recommend subscribers should invest in this trade?

Did they say invest 10% of your portfolio in this recommendation? In which case the overall return on the portfolio is 25% with all other things held constant. Or did they say only invest 1%? In which case the portfolio would only be showing 2.5% gain. Recommending an investments or trades without even a slight hint of how much of one’s portfolio should be allocated to each recommendation can severely distort performance claims.

We have come across a number of investment newsletters which entice subscribers with headlines such as “ABC Exploration up 250% since our buy recommendation”, but when you dig deeper you find out that ABC was actually one of fifty other tiny stocks, none of which has gone very far. So even if one took the assumption of an equal amount of capital in each recommendation, the portfolio is only up 5%, perhaps less if the other recommendations have fallen, perhaps a little more if the others have risen. But the others clearly haven’t risen that much, as otherwise they would be headlines too. In fact the other 49 stocks would only have to have fallen 0.1% on average to wipe out the gains boasted in the headline.

One should also note that when questioned on recommendations that have fallen dramatically, some providers of these services will say that they are risky and so only a small amount should be invested in each one. Therefore even if you are lucky to get on the 250% ride, you aren’t going to make a great deal on it, as you are only putting a small amount of money into the recommendation.

Another important dimension is the timing of such recommendations. The recommendation may be up 250% but over what time horizon? What if it has been over 5 years? Well that’s only an annualised return of 28%. Even with just 10 different recommendations at any one time, with all else held constant, thats an annualised return of just 2.8%.

With SK OptionTrader, we post a suggested weighting with every trade we signal, and our service includes a model portfolio of 100 units. So we do not just say buy X, we say buy X with Y units allocated to this trade. This is a far more realistic approach and provides a much more useful and actionable service to our subscribers.

Next, one should examine the clarity of buy and sell signals issued. Some services may claim to have given a sell signal by mentioning something as vague as “it may be prudent to take some money off the table at this point”, or other non-committal lines buried in a thirty something page report. This is not a sell signal. A sell signal should be when the services states clearly and unequivocally to “Sell XYZ”. From that point if XYZ increases, then the service cannot include these gains in its performance, and if it falls then the service can be commended on having avoided a drop.

Similarly a buy signal should consist of “Buy XYZ” and a suggestion of how much to invest in this recommendation. As casual mention along the lines of “this stock appears to offer good value at these prices”, or “technical indications are giving a buy signal” does not constituent a buy recommendation in our opinion. Yet, some newsletters will count it as such if it works in their favour, patting themselves on the back for the great call and measuring large headline making percentage gains from the time of this casual sentence. If this casual comment proves to be wrong, then nothing will be heard of it again and the author will undoubtedly claim that it wasn’t a buy signal. You cannot have your cake and eat it too. If you want recognition for your profits, you must be accountable for your losses.

Of course like any business we have to promote ourselves, so we publish our performance and we are proud of it. But we do not hide our losses and are completely transparent and crystal clear as to what our recommendations are. We have two losing trades. One involved buying puts on SPY, as we thought the S&P 500 was going to decline. It didn’t, we got it wrong and took a loss of 47% on the trade, to which we had allocated 10% of our SK OptionTrader portfolio, so it contributed a 4.7% loss to the whole portfolio. The other was a purchase of GLD puts since we had a large long position on GLD and gold was moving against us, so we bought the puts as a hedge. Gold turned around and so we no longer needed the hedge, so closed the trade with a loss of 26%.

We take responsibility for these 2 losing trades, as we also take responsibility for the 36 winning trades SK OptionTrader has closed to date, our average profit per trade of 41.15%, our 74% return on capital since inception and our current 58.7% annualised return on capital.

We are not claiming to be the best service in the market, simply showing what we are achieving and it is up to you to decide whether we are worth your $199.00.

We do however think that we provide our service in such a way that is more useful and therefore ultimately more beneficial to our subscribers than most outfits, by giving suggested weightings with each trade and reporting our results with full transparency, including of course the most important result of all which the majority do not publish, our annualised return on capital, which is 58.7%. Our full trading record can be viewed here.

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If any service cannot produce a genuine return on capital figure, then in our opinion their subscribers are paying for tips and nothing more. Perhaps newsletters may be entertaining or insightful, but it terms of delivering profits the ROC is crucial to determining the value of the service, especially if the subscribers aim is to make money from the recommendations.

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Reader Comments (2)

Over my many years' of playing the markets I have come across many what I would call "tip sheets", these give buys and sells and try to be homest by giving 24 hours notice so as not to get in before you as as a subscriber and therefore gain an advantage on price. It is only after following these gurus for a long time do you find whether their advice is due to some luck or you hope, some skill which will continue while you are a subscriber. I wish all those who have subscribed to your SK OptionTrader continued success, but being the worlds most sceptical person, I will see you in about 5 years' time, to examine your recommendations and their outcomes, if you are still around.

November 5, 2010 | Unregistered CommenterRyszard Ciesielski

There is nothing wrong with skepticism.

Our web sites have going for about six years and we have built up a following, the gold-prices site has just under 10,000 subscribers and attracts around 20,000 visitors per day. From time to time we have attempted to unearth an options trade that we think will generate a reasonable profit and we do our best to monitor it and give a timely sell recommendation.

This then lead to a number of our subscribers requesting an options trading service, which takes some time to set-up, resource, formulate trading strategies, etc. Its now up and going reasonably well as our trading record indicates with 36 winners out of 38 trades, which suggests that we are either very lucky or that there is a little more to it.

So we look forward to hearing from you in about five years time and wish you every success in the mean time.

November 5, 2010 | Unregistered CommenterGold Prices

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