Opportunity Cost is what you forgo by taking the course of action you chose. Opportunity cost affects traders in multiple ways. For example, if you are spending your days trading and constantly losing, or only making a very small amount, you are giving up the opportunity to make more money doing something else (a job). But of course if you believe trading will eventually produce a big income, then it is worth it to keep trading instead of going to work (keeping in mind of course that trading is work and should be treated as a business).
The opportunity cost I want to talk about is much more frequent though, and it is opportunity cost of the trades you take. At any moment there are potential trades happening. Some have a very low probability and therefore a low profit potential, while others have a high probability and therefore a higher profit potential.
When traders take a low probability trade–when there is no real direction and the price could just as easily go up as it could go down–not only may that trade turn out to be loser, but the trader may be giving up the opportunity to get into a higher probability trade.
This is something to always consider.
As a way to keep myself from “over-trading” and taking poor trades, I constantly ask myself if this trade is the “good opportunity I have been waiting for?” If it isn’t, I skip the trade, because if it isn’t a “good opportunity” then what is it? If I take that poor trade I may actually miss the good opportunity because I am in the poor trade or distracted!
Here is a recent example. Lots of traders like to take positions right before a news release, trying to guess which way the price will go on the news release. This isn’t a wise decision. The price can easily whipsaw back and forth, creating losers out of these traders who tried to bet on the direction before the news release.
On June 3 at 1230 AM (EST) the Australian Reserve Bank released a Rate Announcement, a potentially high impact news release. Had you taken a position before the announcement (low probability) you likely would have been stopped out or finished out of the money as the price whipped back and forth.
Not only that, but you may have been too disgruntled (from the loss) or distracted to participate in the very “easy money” trade that occurred shortly after the announcement. In figure 1 we see the price whipsawing in the moments following the announcement, but then the price consolidates. The upside breakout of that consolidation provided a great low-risk high-probability trade to the upside.
Figure 1. AUD/USD 1-Minute Chart
By thinking in terms of opportunity cost you could have avoided the tough trading in the moments leading up to and just following the news announcement, and been clear headed and ready to hop on the “good opportunity” which followed shortly after, as the real trending move began.
Always ask yourself “Is this the good opportunity I have been waiting for?” If it isn’t, skip the trade, because the good opportunity may be just around the corner, and that’s the trade you don’t want to miss.