Before I begin, hat tip to Micah Brooks for first teaching me this concept.

When it comes down to it, trading is a quality versus quantity question. One is easy to improve, the other hard. Let’s illustrate using a business analogy.

The Metrics that Matter

Today’s story will include a few key metrics to analyze the profitability of a business. I suspect you’re already familiar with basic concepts like revenue, profit, and cost. But let’s add two more to the mix: profit margin and inventory turnover.

Profit margin is calculated by taking profits divided by revenue. For example, if you made $100k on $1 million in revenue, then your profit margin is 10%. Businesses seek to maximize their profit margins through various methods such as reducing input costs or increasing the price of their product.

Inventory turnover measures how many times a company has sold and replaced inventory over a set period. High volume, low margin businesses like grocery stores have a high inventory turnover. This is also born of necessity since they are selling perishable goods with a short shelf-life. Alternatively, firms like a hardware store may see much lower inventory turnover.

You can view your trading account as a store. In your bid for profits, things like inventory turnover and profit margin are important metrics to measure

Let’s compare two trading stores to discover how they might improve their profitability.

The Grocer

Our first trader has a $100k account and has fully embraced the concept of being a high-frequency trader. We’ll call him Mr. Rabbit to reflect his high-speed approach. He is efficient with his capital and always seek to have it at work. Time plays a crucial role in trade management because Mr. Rabbit takes profits quickly and then redeploys the money elsewhere.

Enter trade.

Take quick profits.

Redeploy.

Rinse, wash, repeat.

By redeploying his capital quickly, the turnover of Mr. Rabbit’s account is sky high. Suppose he can invest the $100k twelve times over in a year. In other words, he deployed $100k worth of trades every single month. If we equate this to the revenue generated by a business, Mr. Rabbit’s store scored $1.2 million in revenue for the year.

But remember, revenue is not equal to profits. To translate the $1.2 million in sales to profit we need to know Mr. Rabbit’s profit margin. Suppose it is 2%. That means in total, our furry-footed friend raked in $24k of profits.

Mr. Rabbit’s Metrics

Inventory: $100k

Inventory Turnover: 12

Revenue: $1.2 million

Profit Margin: 2%

Total Profits: $24k

The Hardware Hawker

Our second trader also has a $100k account but plods along at a much slower pace. To reflect her lower frequency of trading, we will call her Mrs. Tortoise. She only turns her inventory over four times a year or roughly once a quarter. Her keen eye for quality limits the number of trades she takes, thus reducing her turnover. Moreover, her management style is one of maximizing gains regardless of the time required. When selling options, she virtually always rides to expiration.

If Mr. Rabbit’s trading business mirrors a grocery, then Mrs. Tortoise’s methods more closely resemble a hardware store. Hers is a business where higher margins and slower turnover are commonplace.

Because of her theta milking efforts, the duration of her trades is quite a bit longer than Mr. Rabbit’s. By turning over the $100k of inventory only four times a year, Mrs. Tortoise’s business generates $400k in revenue for the year.

However, because of her discerning eye and penchant for perfect setups, her profit margin is twice as good as Mr. Rabbits at 4%. All in, she scores $16k of profit for the year.

Mrs. Tortoise’s Metrics

Inventory: $100k

Inventory Turnover: 4

Revenue: $400k

Profit Margin: 4%

Total Profits: $16k

Quality versus Quantity

Now, who would you say is the better trader? As you ponder the question, here are a few others to mull over. What could Mr. Rabbit do better? And what about Mrs. Tortoise?

Here are my observations. The rabbit excels at turnover but could use better profit margins. The tortoise excels at profit margins but could do better turning over inventory.

We’ve now approached the crux of the matter. Trading is a never-ending question of quality versus quantity.

When we say Sir Rabbit needs to improve profit margins what we really mean is he needs to improve the quality of his trades. And, when we say Madame Tortoise could do better turning over inventory what we mean is she could increase the quantity of trades.

Chew on this for a bit, and you’ll soon discover that it’s much easier to improve quantity or the number of trades. Quality is hard. Increasing your profit margin means squeezing more profits out of each trade or increasing your win rate (or both). It’s a lot easier to simply shift from doing five trades a month to 10.

For you options sellers out there, this angle of explanation also adds validity to the idea of return on time invested (ROTI) that I’ve explained many times elsewhere. One of the quickest ways to increase trade quantity is to take profits quicker.

This little story also illustrates the importance of the oft-quoted phrase, “trade small, trade often.” Only those who trade small can trade more frequently without taking inordinate amounts of risk.