HOW TO TRADE WELL

The Components of Trading Well

by
Van K. Tharp, Ph.D.

This article is an excerpt from Part 1 Working on Yourself: The Critical Component That Makes It All Work, from the book, Super Trader: Make Consistent Profits in Good and Bad Markets

I’m a neuro-linguistic programming (NLP) modeler and a coach for traders. As an NLP modeler, I encounter a number of people who excel in something, determine what they do in common, and then determine what beliefs, mental strategies, and mental states are required to perform each task. Once I have this information, I can teach those tasks to others and expect to get similar results. My job as a coach is to find talented people and make sure they learn and follow the fundamentals.

I remember doing a workshop with the Market Wizards Ed Seykota and Tom Basso around 1990. All three of us agreed that trading consists of three parts: personal psychology, money management (which I subsequently renamed position sizing (TM) in my book Trade Your Way ...), and system development. We also agreed that trading psychology contributes about 60% to success and position sizing contributes another 30%, which leaves about 10% for system development. Furthermore, most traders ignore the first two areas and don’t really have a trading system. That’s why 90% of them fail.

Over the years I’ve done extensive modeling in all three areas, and I now disagree slightly with our conclusions in 1990. First, I would argue that trading psychology accounts for 100% of success. Why? This conclusion is based on two findings. First, people generally are programmed to do everything the wrong way. They have internal biases that seem to lead them to do the exact opposite of what is required for success. For example, if you are the most important factor in your trading, you should spend the most time working on yourself, but the majority of people totally ignore the “you” factor in their success. Read over the checklists in this part that deal with good trading. If you’ve worked extensively in all the areas listed, you are probably very successful and are certainly a rarity.

Second, every task I model requires that I find the beliefs, mental states, and mental strategies that are involved. All three ingredients are purely psychological, and so it’s hard not to conclude that everything is psychological.

I now think that there are five components to trading well:

1. The trading process. The things you need to do on a day-to-day basis to be a good trader.

2. The wealth process. Exploring your relationship with money and why you do or do not have enough to trade with. For example, most people believe that they win the money game by having the most toys and that they can have it all right now if their monthly payments are low enough. This means that they save zero dollars and are over their heads in debt. If this is you, it also means that you don’t have enough money to trade.

3. Developing and maintaining a business plan to guide your trading. Trading is as much a business as is any other area. The entry requirements are much easier because all you have to do is deposit money in an account, sign a few forms, and start trading. However, the entry requirements for successful trading require that you master all the areas listed here. That requires a lot of commitment, which most people do not have. Instead, they want trading to be easy, fast, and very profitable.

4. Developing a system. People often consider their system to be the magic secret for picking the right stocks or commodities. In reality, entry into the market is one of the least important aspects of good trading. The keys to a moneymaking system are elements such as determining your objectives and the way you exit a position.

5. Position sizing to meet your objectives. We’ve discovered through our simulation games that 100 people at the end of a set of 50 trades will have 100 different equities. (They all get the same 100 trade results). This extreme variability of performance can be attributed to only two factors: how much they risked on each trade (i.e., position sizing) and the personal psychology that determined their position sizing decision.

Based on the five components of trading well, rate yourself by asking the following questions:

How well have I mastered the discipline of trading well each day? Do I do a daily self-analysis or a daily mental rehearsal to begin each day? If not, why not? (I will give you a lot of ideas about how to improve in this area throughout the Super Trader book).

Do I really have enough money for trading to make sense? If you do not, you probably need to work on yourself and the wealth process.

Do I have a working business plan to guide my trading? If you don’t, you are not alone. We estimate that only about 5% of traders have a written business plan. Then again, perhaps you’ve heard that only about 5% to 10% of all traders are really successful. Super Trader will guide you toward developing this kind of working document.

Do I have a set of objectives thoroughly written out to guide my trading? Most people don’t. How can you develop a system to meet your objectives without having objectives?

How much attention have I paid to the “how much” factor: position sizing? Do I have a plan for position sizing my system to meet my objectives? It is through position sizing that you either meet or fail to meet your objectives.

How much time do I spend working on myself? You have to overcome your psychological issues and develop the discipline necessary to carry out the processes described above, which are necessary for success.

Most of the items described here could be the topic for an entire book. However, my intention was to give you an overview of what is required for successful trading, and my job as a coach is to find talented people and coach them on following the fundamentals I’ve described them here.

About Van Tharp: Trading coach, and author, Dr. Van K. Tharp is widely recognized for his best-selling books and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at www.iitm.com. 

 

MYOPIC LOSS AVERSION

As a slight departure from my usual month end newsletter I write this on a gorgeous day at a café overlooking Bondi Beach with 4 trading days left of the month, and not at the beginning of the new month as usual. This letter is addressed primarily to myself as a source of intellectual reinforcement, but I believe we can all take something from its message.

 

As a discretionary fund manager there are many times when ones market calls do not go exactly according to plan and it is during these times that we need to dig deep into our resolve, to question the basis of our research and our overall methodology and ultimately deliver on our stated objectives. Whilst the current market has moved with more persistence than I anticipated, it has by no means behaved in a manner at conflict with my overall market views. In fact what has developed over the last 6 weeks I believe is a fantastic gift for a sentiment extreme trader such as myself. The most reputable sentiment indicators are currently registering extremes above their 2007 highs with bears in extremely short supply. This combined with momentum indicators stretched to severely overbought levels paints a superb picture for an aggressive market reversal.

 

So let me once again re-look at the stated objectives of the Freestyle REIT Hedge Fund. The objective is to achieve a 30% annual return with a Sharpe Ratio of 1 displaying an asymmetrical return distribution over a full trade cycle of 9 - 12 months. Having a clear objective and sticking to its goals is the key to achieving success, even more so in the face of adversity. Our strategy is very clear in that we look to make outsized returns when market calls are correct and keep losses to a minimum in the event of us being wrong. We have described at length in previous letters that markets behave according to their own time line and hence we accept returns to be asymmetrical as the market doesn't respect a hedge fund managers calendar performance needs. Having reaffirmed the funds objectives and feeling calm about the current portfolio composition it will be good to analyze the financial industries short term bias which places so much pressure on short term performance, consequently at the expense of longer term performance (talk about shooting ones self in the foot).

 

The bias I am referring to is Myopic Loss Aversion; ("MLA") ( Benartzi and Thaler 1995) where too greater emphasis is placed on short term (myopic) performance causing investors to underweight risk and as a consequence underperform. In order to understand where the theory of MLA originated we need to take a few steps back and look at a problem Mehra and Prescott identified in 1985 called The Equity Premium Puzzle which questioned the quantum of the equity premium for stocks over bonds as should be explained using the classical economic paradigm. According to their analysis of +- 100 years of market data the equity risk premium which is the equity return less the risk free rate should have been a lot lower than evidenced by the data, thus implying a far greater need for compensation for taking on market risk than a symmetrical model would suggest.

 

The answer to this puzzle came by way of MLA an adaptation of the seminal work Prospect Theory (Tversky and Kahneman 1979), whereby Benartzi and Thaler used two of its key principles, namely Loss Aversion and Mental Accounting to clarify the problem. These two theories are huge pilllars of the Behavioural Finance landscape and will need far deeper analysis, which we will hopefully get to in future letters but for now it is sufficient to say that Loss Aversion is the thesis that one feels the pain of financial loss a lot more than the joy associated with financial gain. Mental Accounting describes the way we evaluate outcomes to our decision making process, in the case of MLA it refers to the way we frame financial performance in a very narrow time frame.

 

With this basic framework in place let us look at the case in point. The Freestyle Fund believes it takes between 9 - 12 months for it to achieve its stated objective of 30% per annum. Theory tells me and the acid in the pit of my stomach validates the theory that the more frequently I look at performance the greater the likelihood of feeling discomfort, hence the greater the probability of avoiding risk in the portfolio the very source of the funds performance. It is therefore imperative that I put aside the industries need for neatly boxed monthly returns in an effort to stay true to the funds objectives and in so doing by lengthening the funds performance evaluation in line with its objectives we will be able to at this most crucial point in the trade cycle embrace the appropriate amount of risk in order for the fund to achieve its performance goals.  

 

By focusing on the funds last 3 months of small losses and ignoring the superb performance over 15 months it is very easy to become negative and too risk averse at a time when  our market research is pointing to the highest probability of outsized gains for those few mavericks committed to a market reversal. In conclusion, Bavlatskyy and Pogrebna (2006) found experimental evidence supporting a process of tilting the very behaviour responsible for MLA and in so doing neutralizing its damaging effects. I believe the validation of the funds stated objectives and the emotional acceptance of the funds performance time line is great step towards avoiding the bias of Myopic Loss Aversion afflicting fund managers and investors.       

 

BEING A CONTRARIAN IS TOUGH

By Vadim Pokhlebkin Tue, 25 Aug 2009 15:45:00 ET

Raise your hand if you agree with this famous quote from Baron Rothschild, an 18^th century British banker and a member of one of the world's richest families:

 

"The time to buy is when there's blood in the streets." 

 

Good advice, no argument there. OK -- now, how about this adage:

 

"Buy low, sell high."

 

Again, you'd be hard-pressed to find an investor who disagrees. Then why in the world do so few investors actually follow these rules?

 

In October 2007, when the DJIA topped 14,000 -- how many sold their shares? And when stocks scraped the bottom below 6,500 in early March of this year -- how many called their broker and yelled, "Buy, buy, buy!"?

 

It's no stretch to say that in each case, only a small minority of investors acted. The rest waited. At the 2007 top, paralyzed by greed, they waited for "the Dow at 40,000." At the March lows, they waited paralyzed by fear and hope. In both cases, the eternal cycle of greed and fear did what it always does: It transferred money from weak hands to the strong ones.

 

Harsh? Yes. But that's just how the market works. Despite a common misconception, it's not a place where everyone gets rich quick.

 

I will go one step further and suggest that even those gutsy investors who bought at the March lows are hesitating to sell now that the DJIA is almost 50% higher -- thus fulfilling only one part of the "buy low, sell high" adage.

 

Why is it so? The Elliott Wave Principle explains it best: investors herd. Human beings perceive safety in numbers -- and it's very, very hard to break away from the crowd, whether at market tops or bottoms. Being a contrarian is not for the faint-hearted.

 

Still, some manage to do it. Baron Rothschild bought when everyone sold. Sir John Templeton (look up his investment philosophy if you don't know it) sold tech stocks in 2000, and as early as 2004 warned (along with Elliott Wave International's president Robert Prechter) of the real estate bubble, also saying it was "a dangerous time to own stocks."

 

How do these investors do it? Well, some simply have both the uncommon intuition for extremes in crowd psychology and the guts to act while others wait. Others, like Bob Prechter, have a method -- a contrarian method like Elliott wave analysis.

 

The DJIA is up BIG from its March lows. Do you know how much longer the rally may last? Will you know when to sell? Our Financial Forecast Service can give you forecasts on multiple time frames right now. Try some contrarian thinking for a change. (Risk-free, as always.)

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