Is a Paper Profit the Real Deal?

Is a Paper Profit the Real Deal?

Jan 23, 2020

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Okay. I’ve got a question for you… is a paper profit the real deal?

Now, many people say it’s not. They believe a profit only counts when it’s in the bank. Others take a more liberal approach. These people don’t need a bank statement. It’s a case of tallying the gains as they go. For them, a paper profit is every bit as real.

Think about this for a moment. Which type of person are you?

I’ll discuss this further in a minute. I’ll also tell you about a common mistake many traders make, and I’ll explain why you should avoid it. But first, I’m going to tell you about a friend of mine. This is a classic story of money in the bank meaning everything.

So it was 1999. And my friend, Sean, was a bond trader at a global investment bank. He was also making lots of money trading his personal account. Sean was basically the type of trader that lots of people want to be.

Now, Sean was a “contrarian” trader. His strategy was to look for extremes in optimism or pessimism, and then trade in the opposite direction. And one of his favourite plays was gold.

You see, gold was in a bear market. Just about everyone was bearish. It was a textbook contrarian play — just about no one thought gold could go higher.

So here’s what Sean did… he bought an option to buy gold at a much higher price in six months. This meant gold had to rally a lot for the trade to be profitable. And because almost no one thought this was possible, Sean was able to get a lot of leverage. It was a bit like backing a long-shot to win. Even a small bet could produce a big payout.

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

And do you know what. He was right… gold exploded higher. It erased two years of losses in just 11 days. This was one of the biggest reversals ever seen. And my mate was on-board. Sean’s profit was huge — he was up over $1 million. I remember thinking it was the fastest trip to millionaire-status I’d ever seen.

So Sean decided it was time to take profit. The trade was with the options desk at the bank where he worked, so he didn’t expect a problem — closing the trade should have been a formality.

But there was a problem… you see, Sean had held the trade for several months. His employer had been taken over during that time, and the new management didn’t like personal trading. He couldn’t get out.

Eventually, they gave him permission to sell. But the delay was costly. A sharp correction saw his profits plummet. Sean pocketed about $250,000 — a lot of money, but well short of a million dollars.
My friend’s paper profit was anything but money in the bank — it was mostly a mirage.

So when should you count a paper profit? Well, I ask a simple question: Is it reasonable to expect I could sell at the current market price? If the answer is “yes”, then I’m comfortable counting a paper profit as real wealth.

But 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. And you know, I can appreciate this... I'd never go out and spend the profits from an open trade.

But for analysing performance, I believe it's a mistake to exclude open profits and losses. And if you do, it could distort your results considerably. Take my personal portfolio for instance. I revalue it regularly. This tells me what I’d receive if I sold every stock on that day.

Yes, my open profits are paper profits. But they I can quickly turn them into cash. This is a key difference to my friend Sean’s options trade. Even though an open position will fluctuate, it's still a real profit or loss.

A mistake many people make is to say a loss isn't real until they sell. But that’s also wrong. A stock is worth what you can sell it for today... not what you paid for it yesterday. I believe the same holds true for profits.

While it's good to be conservative, your open profits and losses are the real thing. I believe it’s a mistake not counting these simply because they’re on paper.

So that’s all for this week. If you liked this video, or even if you didn’t, scroll down and leave me a comment, or maybe a thumbs up. Also, if you’re watching this anywhere other than my website motiontrader.com.au then head over and have a look.

So until next time, I’m Jason McIntosh, and let’s find some trends this week.

 

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