Psychology

You do not trade the markets. You can only trade your beliefs about the markets... ~ Van K. Tharp ~

What does it mean to say we only trade our beliefs about the markets?

Let’s look at some examples and see what you believe about them:

• The market is a dangerous place to invest. (You are right.)
• The market is a safe place to invest. (You are right.)
• Wall Street controls the markets and it’s hard for the little guy. (You are right.)
• You can easily make money in the markets. (You are right.)
• It’s hard to make money in the markets. (You are right.)
• You need to have lots of information before you can trade profitably. (You are right.)

Do you see the theme?

You are right about every one of these beliefs (whether you said yes or no to any of them) and if you don’t believe in any of these statements, what do you believe instead? You are right about that too! However, there is no real right/wrong answer. Some people will have the same beliefs and agree with you and others won’t.

Therefore, whatever your beliefs about the markets are, they will direct your thinking and your subsequent actions.

What Is a Belief?

Beliefs are a primary way to filter information from the world. Beliefs are judgments, categorizations, meanings or comparisons. They determine how we perceive reality and relationships in reality. What you expect (i.e. your reality) depends upon your beliefs and they are largely unconscious. Every sentence in this document represents one or two beliefs, including this one.

One of the beliefs that is most productive for good trading is the belief that you are totally responsible for your own results as a trader. When you adopt this belief, then you can learn from your mistakes. However, if you tend to blame someone else (your broker, your spouse, the person giving you tips) or even the market for the results that you get, then you will tend to repeat the same mistakes over and over again.

When traders “own their problems” and assume responsibility for the results produced, they then discover that their results come from some sort of mental state, which either allowed them to 1) follow their rules, 2) not follow their rules, or 3) trade without having any rules.

When traders take the time to write down all their beliefs (about themselves, the markets, money etc.), then they can establish a much better idea of what they want to trade, how they want to trade and they can also see flaws in their thinking much easier. It is valuable to know which beliefs support you as a trader and which ones hinder your progress.

What Is a Mental State?

Every task has an optimal mental state that will allow you to accomplish that task effortlessly. For example, to execute a trade you benefit from courage and total commitment. Fear, in contrast, is a big disadvantage as a mental state for executing trades.

Mental states are primarily what most people call discipline or emotional control. Examples include,: being impatient with the markets, being afraid of the markets or being too optimistic about the markets.

Controlling your mental states is just part of the answer, but when you can see that you are the creator of your own results as a trader, then you have come a long way and can really make progress.

What Is a Mental Strategy?

To understand mental strategies, you have to understand how people think. People think in their five sensory modalities, that is, in terms of visual images, sounds, feelings, taste and smell.

A mental strategy is the step- by -step way in which you use these modalities; it is the specific sequence of your thinking. For example, the most effective strategy for the action step of executing a trade is to 1) see the signal; 2) recognize internally that this is the signal you decided you should take; 3) feel good about it; and 4) take action. If you do anything else, you probably won’t be able to take action or you will be very slow to act.

The Psychology of Trading

Once you have a clear understanding of which beliefs, mental states and mental strategies are the core factors in top trading performance, you can then teach the same skills to others and have them perform well too. And when you can see this success duplicated in others, which we have been able to do in most aspects of trading, then you know you have a workable model.

The Key Psychological Traits of Top Traders are:

1. Personal Responsibility
2. Commitment
3. Their psychological “profile”
4. Working on personal issues (e.g., self sabotage)

Trading fundamentals include the Ten Tasks of Trading:

1. Self Analysis
2. Mental Rehearsal
3. Low-Risk Idea Development
4. Stalking
5. Action
6. Monitoring
7. Abort
8. Take Profits
9. Daily Debriefing
10.Periodic Review

Traders need to be reminded of these tasks and to eliminate any self-sabotage that keeps them from following the tasks. Van teaches all of these steps in detail in his various products and workshops.

Van Tharp believes that everything revolves around your beliefs, mental states and mental strategies, so with that in mind, everything about trading is 100% psychological, including why and how you trade or which system you will follow or build.

Many traders have a hard time “believing” this and it is almost the antithesis of what people learn in academic finance. So only you can decide whether it is worth the time to learn more about yourself and the psychological aspects of trading.

If you would like to learn more (this is one of Dr Tharp’s specialties), then we can certainly guide you in the right direction. You just might be surprised at the results!

People get exactly what they want out of the markets. Most people are afraid of success or failure. As a result, they tend to resist change and continue to follow their natural biases and lose in the markets. When you get rid of the fear, you tend to get rid of the biases ~ Van K. Tharp, Ph.D.

About Van Tharp: Trading coach, and author Dr. Van K. Tharp, is widely recognized for his best-selling book Trade Your Way to Financial Freedom 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 http://www.iitm.com/.

Why Most People Fail to Make Money Trading

Trading mistakes are what differentiates profitable traders from losing traders. A mistake is defined as something which prevents the accurate implementation of the trading plan. Winning traders make few, if any, mistakes implementing their trading plan, and therefore benefit from the full profit potential of their trading systems. A losing trade is not a mistake if the trading plan has been followed correctly.

Trading mistakes can be split into the following 3 areas:

• Methodological
• Psychological
• Typographical

Methodological

Methodological mistakes are made when the pre-defined method, process, or system is not followed, and therefore trading is being done at random. Implicit in this category of mistakes is trading without a plan; since if you are not trading with a plan how can you know if you are trading the plan consistently. Other mistakes in this area include:

• Altering your plan while the markets are open.
• Not having a rule defined for every conceivable eventuality (i.e. trading with an incomplete plan)
• Trading a plan that has a negative expectancy (any profits are made by chance, and the longer you trade this plan the more likely it is that you will lose)

Methodological mistakes can be eliminated by having a complete and well-defined trading plan before trading commences.

Psychological

Psychological mistake are ones where you have a good and complete trading plan, but you fail to implement it accurately for personal reasons. These include fear, greed, excitement, boredom, tiredness etc. Examples include:

• Not taking a trade that matches your entry criteria
• Exiting a trade that does not match your exit criteria
• Adding to a trade that does not meet you addition rules
• Not exiting a losing trade when exit criteria are met
• Trading whilst sick or tired
  

If psychological mistakes cannot be controlled and minimized, the profit potential of your trading system will not be realized and the result will likely be losing, or erratic trading.

Typographical

Typographical errors are ones where data relating to your trading system, or order entry or management information is mis-keyed. This includes:

• Mis-typing symbol, size, order type, etc when entering an order.
• Putting the wrong price on a stop order.
• Any other data entry errors that cause you to either miss a trade, or incorrectly implement a trade.

These are the easiest types of mistakes to make, but are also the easiest to prevent with good automation procedures, or data entry checking and validation procedures.

Summary

Mistakes must be eliminated where possible, and minimized where not possible. The traders that consistently make money are the ones who are making few mistakes, and are taking the money from the traders who are. In order to eliminate mistakes you must be aware they are occurring so it is very important to keep a trade diary and record every trade, especially ones where a mistake is made. Usually this mistake can be attributed to an incomplete plan and the plan can then be enhanced to prevent a similar mistake being made in the future.

If repeated psychological mistakes are made, it may be time to admit that you are not suited to be a trader and need to find someone who can either trade your capital, or implement your trading system for you.


Paul King
PMKing Trading LLC
Source: http://www.pmkingtrading.com

Why Trade Systems?

I am often amazed at the unbelievable amount of worthless investment advice offered. The reason I say that is because the vast majority of advice offered seems to be nothing more than opinions based on little to no real scientific research. Its similar to the countless “cures” that you can find in health food stores. Nothing more than untested and unsubstantiated claims.

My opinion on this continues to get stronger and stronger over the years. I have tested countless methods that the authors purported to be “money makers” only to see the vast majority of these ideas being nearly worthless. Many of these authors are very respected and have well established followings. In some cases they have near celebrity status!

A good example of this is Chart Patterns. There is an entire industry built on chart patterns. Things such as triangles, pennants, rising wedges, trend lines etc etc. Unfortunately, if you ever try to code these patterns you will first find that patterns are extremely subjective. A hundred people looking at the same chart will see 100 different patterns. In addition, most “obvious” patterns are only obvious after they have confirmed themselves. This is nothing more than hindsight bias. When you put the rubber to the road and actually test many of these “chart patterns” they don’t hold up at all. I find the same true for things such as Gann Lines, Fibonacci numbers, Elliot wave, the list goes on and on.

Think about this, you wouldn’t put a powerful drug in your body that was not first rigorously tested in a scientific manner would you? Why would you expose your financial health to ideas that were not also rigorously tested in a scientific manner? It’s amazing the financial advice and "tips" people will take based on the flimsiest of evidence! This was hammered home recently with all the multimillion-dollar salaried Wall Street analysts who lost their investors billions. In some cases this was disingenuous advice, in other cases it was just stupid predictions based on untested theories about what “should” happen. "Looks like a cup and handle base"????

What I am suggesting is that the ideas you use should be ones that have gone through rigorous scientific analysis. Ideas that have been broken apart in hundreds if not thousands of different ways and then tested across thousands of different examples to see how they would have performed. Furthermore, trading good systems can help to reduce the psychological sabotage so prevalent when trading without a mechanized method. The demons of fear and greed and panic and euphoria can be kept in check better.

The following text was taken from a popular trading book, Decision Traps, by J. Edward Russo and Paul J.H. Schoemaker. In this book, nine different types of decisions were tested using three different decision methods. The accuracy of the decisions was then compared and analyzed for effectiveness in predicting final outcomes. The investigator looked at different types of decisions, predicting grades, predicting recovery from cancer, performance of life insurance salesmen, as well as predicting changes in stock prices. He used three different decision making processes: an Intuitive Prediction Model, a Subjective Linear Model, and an Objective Linear Model.

Decision Models

• Intuitive Model = Discretionary Trader
• Subjective Model = Technical Trader
• Objective Model = Systems Trader

Intuitive Prediction Model (Discretionary Trader)

Intuitive prediction is defined as making a decision without the use of any objective or quantifiable data. For instance, in trying to predict the academic performance of graduate students, the researches asked their advisors to do so without seeing their grades and just by talking to them. The decision-makers had to rely on their intuitive impressions and any other factors they thought relevant (how the student dressed, their language skills, grooming habits, etc.). This is the same way discretionary traders make trading decisions - using intuition and gut instinct. In predicting the stock prices, it is highly likely that the researcher engaged a discretionary trader to predict the future prices of stocks.

Subjective Linear Model (Technical Trader)

A Subjective Linear Model is a much more complex decision making process. It starts with the interviewing experts in a field and learning how they make decisions. The researcher literally asks the expert how he or she makes decisions and they respond by explaining how they make their predictions. Although these experts are not using quantifiable data, they have enough experience and knowledge in their field to be successful. This decision making process is then outlined by the researcher.

For instance, a physician, highly experienced in treating cancer, has probably become fairly adept at predicting the life expectancy of his patients, even without using any objective data.

The researcher interviewed the physician and attempted to determine exactly how the physician made this assessment. Then the researcher put this newly quantified data into a regression model and attempted to predict the life expectancy of cancer patients.

This is very similar to how a technical trader makes decisions. He goes to seminars and reads books to learn how the experts make decisions using technical indicators. He then takes what he learns and attempts to trade like he experts. In a sense, he does his own regression model of the expert's process to make trading decisions.

Objective Linear Model (System Trader)

For the Objective Linear Model, the researcher developed an objective model based on historical tests and observations to predict results. This is defining and using quantifiable data, running historical tests, and then using the results of the tests to predict future outcomes.

For instance, the researcher would look at reams of physical data from terminal ill patients, and correlate the data with how long the patient lived. After running the historical tests, the researcher would then obtain the physical data form cancer patient, and using the historical test data, attempt to predict how long that cancer patient will live.

This is exactly what a system trader does. He runs historical tests and then uses that data to take a position in the market. He uses objective quantifiable data tested historically to make his trading decisions. The following table shows the results of tests.

In every case, the Subjective Linear Model outperformed the Intuitive Prediction Model bit only by a small margin. If you look at predicting the changes in stock prices, the Subjective Linear Model only slightly outperformed the Intuitive Prediction Model.

The real insight from this study comes when we look at the results of the Objective Linear Model. In every case, the Objective Linear Model outperformed both the Intuitive Prediction model and the Subjective Linear Model. In some cases, the improvement was minor, and in others it was substantial. It is interesting to observe that the greatest improvement came when using the Objective Linear Model in predicting the changes in stock prices!

Hopefully I have caused you to think a little bit about using thoroughly researched systematic methods in your trading (if your not already). My nearly 12 years of computerized research has given me the opinion that roughly 90% of the methods in the public domain (books, seminars etc.) has little to no real value.

Unfortunately, many charlatans and snake oil salesmen have used the guise of computerized research to sell equally worthless creations. The real key is learning how to use the power of computerized research to develop robust trading systems without falling into the many possible traps including optimization.

All of our systems have been rigorously tested and researched in a manner that we feel would meet the standards of the most knowledgeable and successful system traders.

Feel free to email or contact us with any questions or comments on this subject. dhoffman@traderstech.net

A study by Harvard Business School professor John E. Lintner found that including futures in an investment portfolio "reduces volatility while enhancing return". And that such portfolios "have substantially less risk at every possible level of return than portfolios of only stocks or only stocks and bonds".


Source: www.traderstech.net

Markets and Change: The Perfect Storm

TurtleTrader, best wishes for bringing sane thinking to the financial markets.

Dr. Alexander Elder

Are you ready for the next perfect storm in the financial markets? Your plan is not just buy and hope is it? Are you ready for the unexpected change?

Change alone is unchanging. In other words, the only thing that stays the same is change. Many have voiced that sentiment, but it is safe to say Heraclitus was the first (roughly 2,500 years ago). But what did Heraclitus mean? Chances are he rose from the same bed each morning, ate a similar breakfast, interacted with the same or similar people, had many days that looked like other days, and overall led a fairly straightforward and predictable existence. The existence of routine seems to contradict the idea of constant change. But does it really? Yes and no. Let's take a closer look.

Heraclitus' observation was the seed that grew into modern day chaos theory. A chaotic system is one that obeys a given set of rules, but is too complex to predict due to the high number of variables involved. Consider the game of chess: wooden pieces confined to 64 squares on a board, guided by simple rules a child could learn. Yet there are more hypothetical outcomes for a game of chess than there are particles in the known universe. With enough variables in play, any rule based system becomes chaotic, observable and measurable but too complex for prediction. Period.

After a million games of chess that all bear similarities but are all different, we can get a better feel for what Heraclitus meant. The game itself is in flux, but the structure of the game is constant. The outcome is always different in some way, but the rules are always the same.

Consider financial markets: price must either go up, down or sideways. Whether the time frame is one second, one hour or one year, one of the three outcomes must occur. No advances in technology, no leaps of modern science, no radical shifts in perception will ever alter this fact. Thus the trader does not need to predict the future, or even attempt to predict it. He only needs to know the longstanding rules of the game and abide by them. If the market goes up, he is long. If the market goes down, he is short. Price is nothing more than a collective perception of reality. When reality changes, perception changes. When perception changes, price changes. And if you can react properly to price changes, you can profit.

Read Bestselling Book Trend Following and visit the Trend Following Blog at Michael Covel

What makes a good trader?

Although many skills are required to be successful in the trading business, the main ones are listed below:

• Discipline
• Confidence
• Patience
• Computer Skills
• Mathematical and Statistical Skills
• Logic and Problem Solving Skills

Discipline

Although it is relatively easy to create a trading system that should make money, it is very difficult to actually implement that system consistently without discipline. Each and every trade must be placed accurately and in a timely manner in order to realize the profit expected of the system. We have spent considerable effort automating every aspect of our trading to ensure systems are implemented accurately and efficiently, and developing mental discipline to ensure the discretionary part of any system is handled consistently.

Confidence

Without confidence in your trading systems and process, it is impossible to continue to trade through a losing period without modifying or abandoning your systems at the worst possible moment. We have done extensive research and testing to ensure all our trading systems are based on a fundamental way the markets work in order to have extreme confidence that they will continue to be profitable in the future.

Patience

For significant amounts of the time, even a good suite of trading systems can have poor or flat performance. It is very important to be patient through these flat periods and not deviate from your trading plan, or make trades through boredom, or the need for action.

Computer Skills

In the highly automated and electronic markets of today it is essential to have a high level of computer expertise in order to compete with other traders. We have extensive expertise in systems analysis and design that we have applied to the trading business in order to automate almost all of our trading processes. The required backup technology and procedures are also in place to ensure uninterrupted operation of all our trading systems.

Mathematical and statistical skills

An ability to use mathematics and statistics to accurately estimate the effectiveness, tradability, and profitability of a trading system is essential to the success of a trading business. We have developed proprietary methods to develop, test, and implement all our trading systems with a high level of predictability using advanced mathematical and statistical techniques.

Logic and Problem Solving Skills

A trading system is really an answer to the problem of creating a strategy that overcomes trading costs (commission, slippage, and spreads) and tilts the odds of success in your favor enough to make a predictable profit. We have extensive experience in business analysis and problem solving that we have applied to the trading domain to create effective solutions to the problems of trading.

Paul King
PMKing Trading LLC
Source: http://www.pmkingtrading.com/

Technical Analysis

First a definition - Technical Analysis is a method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security's intrinsic value but rather use charts to identify patterns that can suggest future activity.

But most often than not so called technical analysts will say it works unless it doesn't.

There are traders who say they are successful with Stochastics. Others swear by moving averages. Still others track open interest, seasonal patterns, cycles, or changes in volume. Technical analysis is all based on indicators and charts. My belief, which is likely ridiculed and discounted by technical analysts everywhere, is that technical analysis indicators are useless to the average trader when used by themselves. They are information filters, not trading systems. Allow me to illustrate, for those of you who haven't left yet.

See, my definition of a useful standalone indicator is one that works so reliably that it is a big surprise when it doesn't work, and I can instantly recognize that failure and do something about it. To me, "useful" is not a label I'd apply to an indicator that works 40% to 60% of the time, and has long periods of indeterminence where it neither signals a clear entry or a clear exit.

Look at any book that illustrates the Stochastic oscillator. It will provide a chart and highlight how at overbought levels, the fast line penetrates the slow line above the 75% line, and sure enough, a downward surge in the market ensues. Look ahead of or behind that example on the same chart, and I almost guarantee that you will see examples of the same indicator doing the same thing, but without any kind of similar market motion occurring. This is a good skill to practice; instead of looking at the examples an author provides for confirmation of the signal, go looking for places where the signal didn't work. If you find a fair number of them, then you can assume that you will lose at least as often as a failed signal occurs.

Crossing moving averages? They cross all the time, back and forth, without a cross being very meaningful to market action. Think about the underlying fundamental statement that the indicator is making, rather than just looking at the picture. An 18/40 crossing pattern means this: "When the average closing price for the last 18 days becomes less than the average closing price for the last 40 days, then the market is going to travel downwards for a while." Really? Why? What fundamental market force does this point to? And shouldn't you have gotten in 18 days ago, when the market covered all that bearish ground? What if the downswing only has 20 days worth of motion in it? From where I sit -- and it's not a crowded room, believe me -- you need an indicator like this to be startlingly accurate in order to profit from it on its own merit. Even 60% accuracy is nowhere near good enough. You want 80%, or better than that.

Trend lines in technical analysis? Well, I like trend lines, but I think the only really good application of them is in the support (or resistance) of a trend. If you use them as top and bottom pickers, you are asking for trouble. And the big reason they're somewhat useful as a tool is that your risk is definable. If the market penetrates the line, you're out, no reversal, no messing around. Do I trade trend lines by themselves? No.

Momentum measurements, moving averages, seasonal patterns, cycles, trend lines, median lines; all of these technical analyst indicators come under the heading of "it works unless it doesn't". This is one of my favorite futures phrases (well, DUH, you say, if you've read more than one of my articles). If you are enamored of one of these indicators, go grab some charts and look for exceptions. If you don't spend more than twenty seconds before you find your first one, then you've hit something that's very likely to fail too often.

Does that mean you should throw away all technical indicators and never use them?

Heck, no. What it means is that you should be extremely wary of using any indicator BY ITSELF, without additional thought, and you should be extremely wary of anyone who is selling something they bill as the ultimate standalone indicator. Some folks do use Stochastics successfully, but they also use its signals under restricted market conditions, and have a clear strategy for what to do when it doesn't work out. A pattern or a moving indicator or some kind of arithmetic relationship is a filter to help you block out market information you don't want. But unless you have a one-in-a-million indicator that I've never seen before, using it as the sole decision maker in your trading world will just lead to losses.

Yes, many experts extol and defend a variety of indicators, but it also seems that a lot of the experts and market gurus have been inhaling from the Kreem Wip can a little too often, except when they occasionally and accidentally make a good prediction. The conventional wisdom and advice in the marketplace is causing 90% of the new traders to lose what they have. Reliance solely on demonstrably useless signal generators is part of that conventional wisdom and practice. If you really want to throw your money away, why not just send me a check instead? I promise to enjoy myself, and I’ll even write you while I’m on vacation.

Source: www.financial-spread-betting.com

Trading To Win vs Trading To Not Lose

Once upon a time three people each gave $100,000 to a money manager in what they hoped would be a highly profitable venture. The money management firm adhered to a carefully tested trend-following methodology. It set up separate accounts for each client and managed each of the accounts identically. Risk never exceeded 3.5% of capital on any market traded, and the average historical loss per losing trade was under 2%.

The first client was retired and filled with wanderlust. So, he decided to take off and travel the world. He didn't return for 14 months. In his stack of mail when he arrived home were 14 brokerage statements. He sifted through them and opened the most recent one. He was pleasantly surprised to discover that his initial investment had grown from $100,000 to $227,000.

The second client was also hoping for above average returns on her $100,000 investment. As soon as she received her monthly brokerage statements, she quickly opened them to see how well her account was doing. For four months in a row, she watched her account balance grow from $100,000 to $170,000. Needless to say, she was thrilled.

Then, however, things seemed to change. Over the next two months, she watched her account balance fall from $170,000 to $161,500 and then to $133,000. That $37,000 drop in two months really spooked her. She worried that, if it were to continue, she might be back to breakeven or even worse. She called the manager and closed her account, walking away with $137,000.

The third client was different. He had a lot of time on his hands and was computer literate. He loved the idea that he could check his account online anytime, 24 hours a day. Since he was home most of the time, that's exactly what he did.

For the first month, he only checked his account once or twice. At the end of the first month, he was pleased to see his account was up by over $20,000. The next month, he decided that he wanted to take a closer look and see how the manager achieved such fine returns. At least once a day, he logged onto his account and tried to understand it.

As he watched his account day after day, however, he became nervous. On some days, he'd see his balance grow by as much as $15,000, only to see it drop $5000 the next. He wondered what in the world was going on. So, instead of checking his account daily, he decided he'd better watch it at least two or three times a day. Sometimes he'd see nothing at all; other days, he'd see his balance change dramatically. Although his account was up another $20,000 at the end of the month, he found the movement in his account to be intolerable. He called the manager, closed the account, and walked away with $140,000.

There was one money manager handling three identical accounts in an identical fashion. After the first two months, each account had grown by $40,000, but the third client had quit. After another four months, the remaining two accounts had grown by at least $37,000, but the second client had withdrawn. After 14 months, the first client, who had not quit, saw his account grow from $100,000 to $227,000.

What set these clients apart from one another?

Their investment was conceptualized on one timeframe, but two of the clients managed the investment on a shorter horizon. We see the same dynamic among traders who get shaken out of good trade ideas when they replace their profit targets with tick-by-tick market scrutiny. Take Friday's trade, for example. Shortly after the jobs report, we spiked to 1324 on the S&P futures, pulled back, and then failed to take out that level as interest rates soared. By the time the market opened for its regular session and bounced back to 1322, market weakness was apparent. As I posted to my research blog, only two of the 17 stocks I track in my basket of representative issues were making new highs for the week despite the seeming S&P strength. A trade back to the previous day's midpoint of 1316 was statistically likely, providing quite a few points of profit potential. A couple of upward jukes of more than a point each, however, were enough to scare many traders out of milking that trade.

Anxiety results from the perceived threat of uncertainty. Once we have a profit in a trade, we have something to lose. Uncertainty is now perceived as a threat. That leads us to cope by asserting (over) control, managing the trade on a different timeframe from the one that had initially led to the trade. At that point, we are no longer truly managing the trade. Instead, we're managing our own anxiety.

That is the very definition of emotional disruption of trading: when what we do to avoid loss prevents us from winning. The ability to tolerate uncertainty separates the trader who trades to win from the one that trades to not lose. We can only benefit from demonstrated edges in the market if we can allow those edges to unfold. But how can we learn such patience? Brett's next article will outline ways we can improve our ability to sit in good ideas.


Adam Mann is a technical writer with Wildwood Partners, LLC, an Arizona-based firm that researches and develops trading strategies across multiple markets. Over the course of eight years, Wildwood Partners has developed its own proprietary model that has demonstrated above average performance while trading a real-time virtual account. It combines pattern recognition with breakout and trend following concepts.

Brett N. Steenbarger, Ph.D. is Associate Clinical Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical University in Syracuse, NY and author of The Psychology of Trading (Wiley, 2003). As Director of Trader Development for Kingstree Trading, LLC in Chicago, he has mentored numerous professional traders and coordinated a training program for traders. An active trader of the stock indexes, Brett utilizes statistically-based pattern recognition for intraday trading. Brett does not offer commercial services to traders, but maintains an archive of articles and a trading blog at www.brettsteenbarger.com and a blog of market analytics at www.traderfeed.blogspot.com. His book, Enhancing Trader Development, is due for publication this fall (Wiley).

Expectancy

At the heart of all trading is the simplest of all concepts—that the bottom-line results must show a positive mathematical expectation in order for the trading method to be profitable. ~Chuck Branscomb

What is expectancy in a nutshell?

A trading system can be characterized as a distribution of the R-multiples it generates. Expectancy is simply the mean or average R-multiple generated.

What does that mean?

By now you should know that in the game of trading it is much more efficient to think of the profits and losses of your trades as a ratio of the initial risk taken (R).

But let’s just go over it again briefly:

One of the real secrets of trading success is to think in terms of risk-to-reward ratios every time you take a trade. Ask yourself, before you take a trade, “What’s the risk on this trade? Is the potential reward worth the potential risk?”

So how do you determine the potential risk on a trade? Well, at the time you enter any trade, you should pre-determine some point at which you’d get out of the trade to preserve your capital. That exit point is the risk you have in the trade or your expected loss. For example, if you buy a $40 stock and you decide to get out if that stock falls to $30, then your risk is $10.

The risk you have in a trade is called R. That should be easy to remember because R is short for risk. R can represent either your risk per unit, which in the example is $10 per share, or it can represent your total risk. If you bought 100 shares of stock with a risk of $10 per share, then you would have a total risk of $1,000.

Remember to think in terms of risk-to-reward ratios. If you know that your total initial risk on a position is $1,000, then you can express all of your profits and losses as a ratio of your initial risk. For example, if you make a profit of $2,000 (2 x $1000 or $20/share), then you have a 2R profit. If you have a profit of $10,000 (10 x $1000) then you have a profit of 10R. The same thing works on the loss side. If you have a loss of $500, then you have a 0.5R loss. If you have a loss of $2000, then you have a 2R loss.

But wait, you say, how could you have a 2R loss if your total risk was $1000? Well, perhaps you didn’t keep your word about taking a $1000 loss and you didn’t exit when you should have exited. Perhaps the market gapped down against you. Losses bigger than 1R happen all the time. Your goal as a trader (or as an investor) is to keep your losses at 1R or less. Warren Buffet, known to many as the world’s most successful investor, says the number one rule of investing is to not lose money. However, contrary to popular belief, Warren Buffet does have losses. Thus, a much better version of Buffet’s number one rule would be to keep your losses to 1R or less.

When you have a series of profits and losses expressed as risk-reward ratios, what you really have is what Van calls an R-multiple distribution. As a result, any trading system can be characterized as being an R-multiple distribution. In fact, you’ll find that thinking about trading system as R-multiple distributions really helps you understand your system and learn what you can expect from them in the future.

So what does all of this have to do with expectancy?

When you have an R-multiple distribution from your trading system, you need to get the mean of that distribution. (The mean is the average value of a set of numbers). And the mean R-multiple equals the system’s expectancy.

Expectancy gives you the average R-value that you can expect from the system over many trades. Put another way, expectancy tells you how much you can expect to make on the average, per dollar risked, over a number of trades.

So when you have a distribution of trades to analyze, you can look at the profit and loss of each one of the trades that was executed in terms of R (how much was profit and loss based on your initial risk) and determine whether the system is a profitable system.

Let’s look at an example:







So this “system” has an expectancy of 2R, which means you can “expect” to make two times what you risk over the long term using this system, based on the data that you have available.

Please note that you can only get a good idea of your system’s expectancy when you have a minimum of thirty trades to analyze, and the preference would be to have 100 to 200 trades to really get a clear picture of the system’s expectancy.

So in the real world of investing or trading, expectancy tells you the net profit or loss that you can expect over a large number of single unit trades. If the total amount of money in the losing trades is greater than the total amount of money in the winning trades, then you are a net loser and have a negative expectancy. If the total amount of money in the winning trades is greater than the total amount of money in the losing trades, then you are a net winner and have a positive expectancy.

Example, you could have 99 losing trades, each costing you a dollar. Thus, you would be down $99. However, if you had one winning trade of $500, then you would have a net payoff of $401 ($500 less $99)—despite the fact that only one of your trades was a winner and 99% of your trades were losers.

We’ll end our definition of expectancy here because it is a subject that can become much more complex.



Van Tharp has written extensively on this topic and it is one of the core concepts that he teaches. As you become more and more familiar with R-Multiples, position sizing and system development, expectancy will become much easier to understand.

To safely master the art of trading or investing, it is best to learn and understand all of this material. Although it may seem complex at times, we encourage you to persevere because like any worthwhile endeavor, as soon as you truly grasp it and then work towards mastering it, you will catapult your chances of real success in the markets.

Money Management / Position Sizing

Money management is a very confusing term. When we looked it up on the Internet, the only people who used it the way that Van was using it were the professional gamblers. Money management as defined by other people seems to mean controlling your personal spending; giving money to others for them to manage, risk control, making the maximum gain, plus 1,000 other definitions.

To avoid confusion, Van elected to call money management "Position Sizing." Position sizing answers the question, "how big of a position should you take for any one trade?"

Position sizing is the part of your trading system that tells you “how much.”

Once a trader has established the discipline to keep their stop loss on every trade, without question the most important area of trading is position sizing. Most people in mainstream Wall Street totally ignore this concept, but Van believes that position sizing and psychology count for more than 90% of total performance (or 100% if every aspect of trading is deemed to be psychological).

Position sizing is the part of your trading system that tells you how many shares or contracts to take per trade. Poor position sizing is the reason behind almost every instance of account blowouts. Preservation of capital is the most important concept for those who want to stay in the trading game for the long haul.

Imagine that you had $100,000 to trade. Many traders (or investors, or gamblers) may just jump right in and decide to invest a substantial amount of this equity ($25,000 maybe?) on one particular stock because they were told about it by a friend, or it sounded like a great buy; or perhaps they decide to buy 10,000 shares of a single stock because the price is only $4.00 a share (equating to $40,000).

They have no pre-planned exit or idea about when they are going to get out of the trade if it happens to go against them and they are subsequently risking a LOT of their initial $100,000 unnecessarily.

To prove this point, we’ve done many simulated games in which everyone gets the same trades. At the end of the simulation, 100 different people will have 100 different final equities, with the exception of those who go bankrupt. And after 50 trades, we’ve seen final equities that range from bankrupt to $13 million—yet everyone started with $100,000 and they all got the same trades.

Position sizing and individual psychology were the only two factors involved.

Van says that this just shows how important position sizing is.

So how does it work?

Suppose you have a portfolio of $100,000 and you decide to only risk 1% on a trading idea that you have. You are risking $1,000.

This is the amount RISKED on the trading idea (trade) and should not be confused with the amount that you actually INVESTED in the trading idea (trade).

So that’s your limit, you decide to only RISK $1,000 on any given idea (trade). You can risk more as your portfolio gets bigger, but you only risk 1% of your total portfolio on any one idea.

Now suppose you decide to buy a stock that was priced at $23.00 per share and you place a protective stop at 25% away, which means if the price drops to $17.25 you are out of the trade. Your risk per share in dollar terms is $5.75. Since your risk is $5.75, you divide this value into your 1% allocation (which is $1,000) and you are able to purchase 173 shares, rounded down to the nearest share.

Work it out for yourself, so you understand that if you get stopped out of this stock (i.e., the stock drops 25%), you will only lose $1,000 or 1% of your portfolio. No one likes to lose, but if you didn't have the stop and the stock dropped to $10.00 per share, you can see how quickly your capital vanishes.

Another thing to notice is that you will be purchasing about $4000 worth of stock. Work it out for yourself. Multiply 173 shares by the purchase price of $23.00 per share and you’ll get $3979. It would probably be around $4000 when you add commissions.

Thus, you are purchasing $4000 worth of stock, but you are only risking $1000 or 1% of your portfolio.

And since you are using 4% of your portfolio to buy the stock ($4000), you can buy a total of 25 stocks this way without using any borrowing power or margin, as the stockbrokers call it.

This may not sound as “sexy” as putting a substantial amount of money in one stock that “takes off,” but that strategy is a recipe for disaster and very rarely happens. Therefore it is best left on the gambling tables in Las Vegas.

To continue to trade and stay in the markets over the long term, learning position sizing and protecting your initial capital is vital.

Van believes that people who understand position sizing and have a reasonably good system can usually meet their objectives through developing the right position sizing strategy.

Position Sizing—How much is enough?

Start small. So many traders that are trading a new strategy start by risking the full amount that they plan on using for the long term with that strategy. The most frequent reason given is that they don’t want to “miss out” on that big trade or long winning streak that could be just around the corner. The problem is that most traders have a much greater chance of losing than they do of winning while they learn the intricacies of trading the new strategy. Therefore, start small (very small) and minimize the “tuition paid” to learn the new strategy. Don’t worry about transactions costs (such as commissions), just worry about learning to trade the strategy and follow the process. Once you’ve proven that you can consistently and profitably trade the strategy over a meaningful period of time (months, not days), then you can begin to ramp up your position sizing.

Manage losing streaks. Make sure that your position sizing algorithm helps you to reduce the position size when your account equity is dropping. You need to have objective and systematic ways to avoid the “gambler’s fallacy.” The gambler’s fallacy can be paraphrases like this: after a losing streak, the next bet has a better chance to be a winner. If that is your belief, then you will be tempted to increase your position size when you shouldn’t.

Don’t meet time-based profit goals by increasing your position size. All too often, traders approach the end of the month or the end of the quarter and say, “I promised myself that I would make “X” dollars by the end of this period. The only way I can make my goal is to double (or triple, or worse) my position size. This thought process has led to many huge losses. Stick to your position sizing plan!

We hope this information will help guide you toward a mindset of capital preservation on your journey toward successful trading. I have talked to many folks who have blown up their accounts. I don’t think I have heard one person say that he or she took small loss after small loss until the account went down to zero. Without fail, the story of the blown up account involves inappropriately large position size or huge price moves, and sometimes a combination of the two. ~D.R.Barton

About Van Tharp: Trading coach, and author Dr. Van K. Tharp, is widely recognized for his best-selling book Trade Your Way to Financial Freedom 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 http://www.iitm.com/.

Risk and R-Multiples

Knowing when you’re going to exit a trade is the only way to determine how much you’re really risking in any given trade or investment. If you don’t know when you’re getting out, then in effect you’re risking 100% of your money ~Mel

Van says that risk is the amount of money you are WILLING TO LOSE if you are wrong about the market. So his definition of risk is how much you’ll lose per unit of your investment (i.e., share of stock or number of futures contracts) if you are wrong about the position that you have taken.

This is called the initial Risk or (R) for short.

One of the key principles for both trading and investing success is to always have an exit point when you enter a position. Trading without a pre-determined exit point is like driving across town and not stopping for red lights—you might get away with it a few times but sooner or later something nasty will happen.

In fact, the exit point that you have when you enter into a position is the whole basis for determining your risk, R, and the R-multiples (i.e., risk /reward ratios) of your profits and losses.
Your exit point can be either a percentage, in points or in dollar terms. For example, William O’Neal says that when you buy a stock, you should get out when it loses 7-8%. Another trader proposes a philosophy of getting out of a stock when it moves 1-2 points against you.

Tell me more about stops.

A stop is basically a preplanned exit. Van says that having stops prevents disaster even though this strongly goes against the grain of the long-term buy and hold philosophy.

When the price hits your stop point, you exit the market. A trailing stop, basically adjusts that stop when the market moves in your favor, thus giving you a profit-taking exit as well.

For example, if you buy a stock at $30, and have a 25% stop, then you would exit the trade if the price drops 25% to $22.50.

In a trailing stop example: You buy the same stock at $30 (with the initial stop at $22.50) but if the stock moves up to $60, your 25% trailing stop would also move up with it and would be placed at 25% of $60, which is $45.

In other words, you would get out of the trade if the stock turned and dropped to $45.00 but because you bought it at $30, you would have locked in half your profit or $15. The trailing stop, in other words, moves the exit point in your favor as the price moves in your favor. BUT you must never move it backwards. Thus, if your stock moves down from $60 to $50, you would still keep your exit at $45, 25% away from the high of $60.

In Van’s opinion, this kind of stop is a safe form of buy-and-hold. You could be in a stock for a long time, but if something fundamental changes, it gets you out.

As an example, JDSU went from about $12 in February 1999 to a high of nearly $150 in 2000 (prices are adjusted for a number of share splits). A 25% stop would have kept you in the entire move. You would have been stopped out in April of 2000 at a substantial profit. However, if you had used a buy and hold philosophy, the same stock hit a low of $1.58 in October 2002. You might never get back to breakeven (an 800% gain from current prices) in your lifetime, but the stop would have totally allowed you to avoid that fall. In addition, it would have gotten you out of stocks like Enron and WorldCom before any of them became headlines.

There are many reasons for using tighter stops and you will probably need to use them for a variety of different trading styles. We are simply suggesting 25% stops as a substitute for the “buy and hold” philosophy.

We are not going to get any further into stops at this point because we want to get back to talking about risk. Just remember, you need to know when you are getting out of a position (your exit point or stop) to determine your risk.

Tell me more about Risk or (R).

Risk to most people seems to be an indefinable fear-based term. It is often equated with the probability of losing, or others might think being involved in futures or options is “risky.” Van’s definition is quite different to what many people think.

As far as Van is concerned, risk is definable.

Many people in the investment world are overly optimistic about the trades that they make. They don’t understand their worst case risk or even think about such factors.

Instead, people are seduced by trading terms such as “options” “arbitrage” and “naked puts,” Or, they buy into the academic definitions of risk such as volatility, which make for good theoretical articles by academicians, but they totally ignore two of the most significant factors in success. The golden rules of trading...

Never open a position in the market without knowing exactly where you will exit that position.

And

Cut your losses short and let your profits run.

So let’s look at the first golden rule in much more detail to be sure that you understand it. That rule is to always have an exit point when you enter a position. The purpose of that exit point is to help you preserve your trading/investing capital. And that exit point defines your initial risk (1R) in a trade.

Let’s look at some examples.

Example 1:

You buy a stock at $50 and decide to sell it if it drops to $40. What’s your initial risk?

The initial risk is $10 per share. So in this case, 1R is equal to $10.

Example 2:

You buy the same stock at $50, but decide that you are wrong about the trade if it drops to $48. At $48 you’ll get out. What’s your initial risk?

In the second example, your initial risk is $2 per share, so 1R is equal to $2.

Example 3:

You want to do a foreign exchange trade, buying the dollar against the euro.

Let’s say that one hundred dollars is equal to 77 euros. The minimum unit you must invest is $10,000. You are going to sell if your investment drops down by $1000.

What’s your risk? What’s 1R?

We made this example sound complex, but it isn’t. If your minimum investment is $10,000 and you’d sell if it dropped $1000 to $9000, then your initial risk is $1000, and 1R is $1000.

Are you beginning to understand? R represents your initial risk per unit. R is simply the initial risk per share of stock or per futures contract or per minimum investment unit.

However, it’s not your total risk in the position because you might have multiple units.

What’s my total risk?

Your total risk would be based on your position sizing and how many shares or contracts that you actually buy.

For example, you may buy 100 of the shares in Example 1, which would be 100 multiplied by the share cost of $50 each. So your total COST would be $5000. But you are only willing to risk $10 per share. So $10 multiplied by 100 shares = $1000 total risk for this position.

In example 2, you also buy 100 shares at the $50 price for a total COST of $5000. However, in this scenario you are going to get out if it reaches $48. So your risk is $2 per share multiplied by the 100 shares - you are only risking $200 of your $5000 investment.

Understanding R-multiples

The next key point for you to understand is that all of your profits and losses should be related to your initial risk. You want your losses to be 1R or less. That means if you say you’ll get out of a stock when it drops $50 to $40, then you actually GET OUT when it drops to $40. If you get out when it drops to $30, then your loss is much bigger than 1R.

It’s twice what you were planning to lose or a 2R loss. And you want to avoid that possibility at all costs.

You want your profits to ideally be much bigger than 1R. For example, you buy a stock at $8 and plan to get out if it drops to $6, so that your initial 1R loss is $2 per share. You now make a profit of $20 per share. Since this is 10 times what you were planning to risk we call it a 10R profit.

You try it:

1. You buy a stock at $40 with a planned exit at $35. You sell it at $50. What’s your profit as an R-multiple?

2. You buy a stock at $60 and plan to get out if it drops to $55. However, when it goes that low, you don’t sell. Instead, you just stop looking at it and hope it will go back up. It doesn’t. It becomes part of the headline business news involving corporate scandal and eventually the stock becomes worthless. What’s your loss as an R-multiple?

3. You buy a stock at $50 and plan to sell it if it drops to $49. However, the stock takes off and jumps $20 in three weeks when you sell it. What is your profit as an R-multiple?

Answers

1. A 1R loss is $5. Your profit per share is $10, so you have a 2R profit.

2. A 1R loss is $5. Your loss per share is $60, so you have a 12R loss. Hopefully, you can understand why you never want to let this happen.

3. A 1R loss is $1. You profit per share is $20, so you have a 20R profit. And hopefully, you understand why you want this to happen all the time.

What's really interesting is that once you understand risk and portfolio management, you can design a trading system with almost any level of performance. For example, you can design a system to trade for clients that would make about 30% per year with only 10% draw downs.

On the other hand, if you want to trade your own account and be a little more risky, you can design a system that will produce a triple digit rate of return as long as you have enough money to do so and are willing to tolerate tremendous drawdowns.

It’s a whole new way of thinking for some, but most successful traders think in terms of risk/reward, which, of course, gives them an edge out there in the markets. Learning to trade and invest in this way will keep you in the game longer and enable you to run with your profits and cut your losses short. And what could be better than that?


About Van Tharp: Trading coach, and author Dr. Van K. Tharp, is widely recognized for his best-selling book Trade Your Way to Financial Freedom 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 http://www.iitm.com/.

What is a Complete Trading System?

Many people think they have a trading system, but what they really have is an entry signal and not much more. A complete trading system has at least the following components:

• Objectives
• Hypothesis
• Market Selection
• Instrument Filter
• Setup Conditions
• Entry Signal
• Position-sizing
• Maximum Loss Stop
• Profit Protection Stop
• Exit Signal

It may also have the following optional components:

• Scaling in and out rules
• System suspension rules (when condition are not favorable)

Note that the objectives are actually part of the system. Unless you clearly define what you are trying to achieve, it is very difficult to design a successful trading system, and even harder to implement it accurately.

Paul King

PMKing Trading LLC

Source: http://www.pmkingtrading.com

System Development

"When I first entered the business of coaching traders most people thought that a trading system was an indicator."

— Van K Tharp

There are folks out there who are obsessed with,
1) Finding the right stock that will make them a fortune and they think there is some magic way to do that.

2) Working on developing a trading system to the point of perfectionism; and never getting around to actually trading.

3) Finding the ideal “system.”

4) Just looking for someone to tell them what to do

Do you relate to any of these scenarios?

Every trader needs a strategy or system to form a framework for their trading. Without a repeatable way to identify and execute trades, one can never be a consistent performer. Basically your system is a roadmap that guides your trading and keeps you from making decisions when you are least able to do so. Meaning that trading can be stressful. It's easy to get distracted. Life goes on regardless of what the market is doing. If you hear news about the market changing or you're running late for your next appointment you are not likely to make good decisions about your trades.

However, many people believe that a trading system is something that is “bought in a box,” something that other people have created with specific technical skills or secret knowledge of the markets that they just don’t have. Well it isn’t.

There are hundreds, if not thousands, of trading systems that work. But most people, after purchasing a system, will not follow the system or trade it exactly as it was intended. Why not? Because the system doesn’t fit them or their style of trading.

One of the biggest secrets of successful trading is finding a trading system that fits you personally. Developing your own system allows compatibility with your own beliefs, objectives, personality, and edges.

Why develop my own system? Isn’t it easier to just go buy a system with proven results?

When someone else develops a system for you, you don't know what biases they might have. Most system development software is designed because people want to know the perfect answer to the markets. They want to be able to predict the markets perfectly. As a result, you can buy software now for a few hundred dollars that will allow you to overlay numerous studies over past market data.

Within a few minutes, you can begin to think that the markets are perfectly predictable. And that belief will stay with you until you attempt to trade the real market instead of the historically optimized market. Many trading accounts have plummeted from this very thinking. One “sure-thing” trade placed without proper position sizing can wipe some traders completely out of the game.

And what if the person peddling the system is just a great marketer who makes their money from selling systems – not from actual trading? How would you know?

In Van’s experience very few people have really good systems and one of his jobs is to teach traders what it takes to develop a complete system for themselves. It isn’t rocket science; it just takes commitment and the right knowledge.

You may be thinking, “But I don’t have the computer or math skills to create a system myself.”

This is one of the biggest misconceptions out there.

If computers, math or anything mechanical terrifies you, that doesn’t mean that you can’t determine how and what you want to trade, which is the basis behind developing your own system. In fact, you’re the ONLY person that really knows what will work for you.

The key thing to remember about system development is that the trading strategy is THOUGHT UP by you because it fits your beliefs, wants, desires and needs. You can hire someone else to computerize your strategy if you want to do that and can’t do it yourself. There are plenty of programmers that will do this for you.

However, not all trading systems have to be computerized! In fact, people have designed and tested successful trading systems for years by hand. Of course computers make things quicker, faster and more efficient, but they are not necessary at all unless you need to use computers to feel comfortable about your trading.

(If you disagree with this, then you probably DO need computer testing to feel comfortable or maybe you believe that when a computer generates numbers, it is more accurate)

If you truly understand what a trading system really is; then this will all make sense. It isn’t complex, unless you choose to make it so!

So What Is a Trading System?

What most people think of as a trading system, Van would call a trading strategy that consists of seven parts:

1. Set up conditions.
2. An entry signal.
3. A worst case stop loss.
4. Re-entry when appropriate.
5. Profit-taking exits.
6. A position sizing algorithm.
7. Multiple systems for different market conditions (if needed).

The set up conditions amount to your screening criteria; For example, if you trade stocks, there are 7,000 plus stocks that you might decide to invest in at any time. As a result, most people employ a series of screening criteria to reduce that number down to 50 stocks or less. For example, you might want to find stocks that are great “value” or stocks that are making new all time highs or stocks that pay high dividends.

The entry signal would be a unique signal that you’d use that meets your initial screen to determine when you might enter a position—either long or short. There are all sorts of signals one might use for entry, but it typically involves some sort of move in your direction that occurs after a particular set-up occurs.

The protective stop is the worst-case loss you would want to experience. Your stop might be some value that will keep you in the trade for a long time (i.e., a 25% drop in the price of the stock) or something that will get you out quickly if the market turns against you. Protective stops are absolutely essential. Markets don’t go up forever and they don’t go down forever. You need stops to protect yourself.

A re-entry strategy. Quite often when you get stopped out of a position, the stock will turn around in the direction that favors your old position. When this happens, you might have a perfect chance for profits that was not covered by your original set-up and entry conditions. As a result, you also need to think about re-entry criteria. When might you want to get back into a closed out position.

The exit strategy could be very simple. It is one factor in your trading of which you have total control. It is your exits that control whether or not you make money in the market or have small losses. You should spend a great deal of time and thought on your exit strategies. This is an important shift in thinking that you will benefit from right now. You don't make money when you enter the market you make your money upon your exit of the market. Far too many people focus only on market entry, or what to buy, rather than when to sell.

Position sizing is that part of your system that controls how much you trade. It determines how many shares of stock you should buy or “how much” you should invest in any given trade. It is through position sizing that you will meet your objectives.

Finally, depending upon how robust your trading system is, you might need multiple trading systems for each type of market. At minimum, you might need one system for trending markets and another system for flat markets. Many professional traders have multiple systems that operate in multiple time frames over many markets to help offset the enormous portfolio dependence of a single trend following system.

___________________________________

Your system should reflect your beliefs )i.e., who you are as a trader and as a person). Many people are just looking for “any system that works,” but if your trading system doesn’t match your beliefs about the markets, you will eventually find a way to sabotage your trading.

In addition, most people have never really taken the time to think through what they truly want from their trading. They don’t have specific objectives in mind. They think they do, but they really don’t. They just have a vague concept in their heads of “I want to make a lot of money.” Yet, objectives are 50% of designing a system that fits you.

Examples of possible objectives:

1. I want to become a full time trader making 30% per year for my clients with potential losses no bigger than half of that.

2. I want to spend less than three hours a week on trading and get the maximum yield out of my system. While I’d like to minimize my downside, I’m willing to risk whatever it takes to get maximum returns, including losing it all.

3. I want to limit my draw downs to no more than 20% at all cost. With that in mind, I’d like to make whatever I can, but minimizing the draw downs is my primary objective.

_________________________________

No system is a money making machine that you turn on and have it print cash forever. Systems must be evaluated and revised to adapt to changing market conditions. And while there are ways to measure the quality of the system, you will never trade a system properly that you don’t feel comfortable trading. In the same way, you might have trouble following the advice of newsletters because you don’t feel comfortable taking certain trades that they recommend.

Improving your trading performance will not come from some indicator that better predicts the market. It comes from learning the art of trading and understanding how to create a trading system that fits your wants, needs, desires and lifestyle.

So ask yourself, how much time and money am I willing to lose trying to trade other people’s systems?

About Van Tharp: Trading coach, and author Dr. Van K. Tharp, is widely recognized for his best-selling book Trade Your Way to Financial Freedom 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 http://www.iitm.com/.

Futures Trading

Trading the commodities and futures markets: A survival game

Everyone who plays with the idea to speculate with commodities or futures, should step back now, take a deep breather and reevaluate this plan. These markets are a game of professionals - and I am inclined to add here - for the likes of them. Numerous studies have shown, that for most private traders (more than 90%) this is a losing game. Being a classic zero sum game overall, there must be someone who wins, and that someone is a minority of professionals.

The slippery churning of brokers, dealers and floor traders

Fees and spreads have to be paid in all financial markets to buy or sell something, but open outcry markets have a tendency to make prices run away in the wrong direction for orders from outsiders that seek to be filled. It remains an unanswered question whether the pure specialist system of listed stocks like the old NYSE, the competing market maker system of NASDAQ, either one combined with a competing electronic order book or the open outcry market is the fairest market. Pit traders like to accuse specialists of having too much power to manipulate their prices. They conceal that specialists have the obligation to make an orderly market with guarantees for reasonable fills. Taking into account that open outcry traders tend to behave coherently, there is no big difference to the specialist's power. Both, but even more the pit traders, resist to compete against a computerized market like an ECN or outright refuse to trade off-floor through a computer system, which would put them on par with other market participants.

Contrarian trading - the advantage of the producer

Price movements especially of futures markets are noisy. There are random fluctuations and self-induced starts or breakouts, which later prove to be non-substantial. This is the fundament for an anti cyclical trading strategy - buy low and sell high, or the other way round. As studies have shown, hedgers, companies or entities which sell what they produce or buy what they need for producing, are the big winners of the commodities and more general the futures markets. They often have a better insider knowledge about what is going on in their market than anyone else. Adding to that, they have the advantage that they are hedging - they actually only need to conduct one side of the trade, either they buy or they sell. This gives them the ability to calculate their trade in the light of their main business, which essentially caps their risk. Also, being better capitalized, they can afford to be longer term oriented.

For the private trader or speculator the contrarian system could prove disastrous. What if the price move turns out to be substantial and results in a trend or at least a new level of price? Combine the counter cyclical market entry with a stop loss? This would be a self contradicting system. A trading strategy which is incoherent is most likely invalid as a system. Having no stop loss is of course even worse. That's how amateurs go broke even in the stock market, which lacks (short or margin operations aside) the infinite risk practically created by leverage in the futures market.

Sometimes producers choose to go with what they see as an emerging trend or what they anticipate to become an enduring new supply and demand situation, so of course they are not bound to the countertrend method, but the long term contrarian trading strategy is only appropriate for them. To emphasize it again, as studies show, they are the big winners.

Following the trend - holy grail or well known secret of trading futures?

The third group of winners in the futures markets are so called commodity trade advisors (CTA), hedge fund managers and some well capitalized and experienced individual speculators. They are primary - as long as they make money - procyclical. They try to buy high and sell higher or vice versa. Is it this easy? No, even the most successful traders of this group suffer severe setbacks, they just won't tell it you. However, they have some advantages over the ordinary speculator. They are bigger in size, they use sophisticated statistical methods to create mechanical trading systems that actually do make money, they know about the importance of good money management and they are generally more experienced.

Creating breakouts of ranges or starts and turns of a trend

The naive way to start trading trends might go like this: Take a chart book, spot some trends and get the impression, that one just had to enter the market here and leave it there to become rich. Well, that's hindsight! To get early on a trend and to ride it as long as possible is easy in hindsight, but hard in reality. First, you have to enter a trend. You are looking for a starting point. That's where the malaise begins. There are strong market players, who produce breakouts of ranges, restarts and turns of trends, because they know many will stumble after them in expectation of a new forming or ongoing trend. If the "trend" turns out to be short lived, they can get out with a profit, because they entered the market at the best levels. Guess what, who pays the bill? Mostly the small private trader, but often enough the professional trend followers, too. That's why the rate of failure among them is much higher than these professionals are ready to admit. Who plays this pattern of buying low, pushing the price through a resistance or turning a trend around in order to hopefully initiating the next round of directional movement? Probably both - producers and trend followers, they just have to have enough capital. The futures markets are exceptionally prone to false breakouts and trends have wilder swings, tempting speculators to leave early or enter late - possibly with a loss. Just have a look at charts, and compare them with the stock market. But be cautious, this is easier said than done - the human mind is a pattern recognizing machine - it will always find the patterns it is looking for.

Using statistics to develop a mechanical trading system

One way to circumvent this problem of an optimistic mind finding occasions not only occasionally is to compile a trading system into an algorithm, which is then followed by a computer without being distorted by sentiments and psychological effects and without making mistakes by lacking discipline. But first one has to identify an edge, which is statistical sound. This means that you can use statistics to crystallize a system, which - so to speak metaphorically - meanders around all pitfalls, all the edges winning players have. Of course there is not much space for winners left, and that's why even professional system traders often lose, too.

The typical private trader has really a disadvantage in this area, he is just not sophisticated enough. He might buy complete systems or programs, which can evaluate trading systems, test them and optimize them, but mostly he is not aware of the mathematics, which are behind all this. Over-optimization or curve fitting is one cardinal sin, second guessing of trading signals another one. The typical trader tends to mix up signals of his system with discretionary decisions or tries to change the system every next time. Emotions have discipline in headlock and chaotic behavior is the result - the opposite of a trading system.

Summary of a zero sum game

Brokers charge a fee and have a riskless income. Floor traders slip away and cut out small but constant gains. Producers milk the markets big with contrarian trading. Deep pockets initiate false movements and let others stumble into their losses. The only chance are trends, but they are rare, and they are carved out by statistically sophisticated system traders or producers with better fundamental foresight. The private trader has to make the sum of the zero sum game become zero. He is there to feed the sharks.

Making things worse: Bad money management

An additional reason why so many novices are losing in this game is the lack of proper money management. To put it simple, they are overtrading. Newcomers intuitively often misinterpret the margin they have to pay as their bet size, and that's why they are overtrading grossly. Usually they are out of the game very soon. But even making bet sizes only slightly too big will make your losses overcompensating your gains on average and your capital will decline over time. This holds true even if you have an edge. Bad money management destroys your advantage - if you have one at all. The reason is mathematics. To make a simple example assume that you have no edge, but put on trades with a very big bet size. A typical gain of 50% of your capital has statistically the same probability as a typical loss of 50%. But to recoup the loss you must win 100%! Even optimistic advantages will get converted into their negative counterpart by what I call the relative-absolute effect.

Source: www.visoracle.com

Stock Investing

How to become rich by investing in the stock market?

Don't be the Investor!

Millions of people are lured into buying stocks, based on promises by the - what it likes to call itself - financial industry. These promises are disguised as only a few outstanding success strategies.

Let us start with what everyone considers to be the more dumb ones:

• Watch TV or read the newspaper and simply go with the flow, do what other do, buy some arbitrary stocks and wait for the big money.

• Have a friend who recommends something or whose gains makes oneself jealous, and be eventually talked into investing or trading.

Here are the ones, which seem to be much smarter:

• Use charts, find patterns and calculate precise entry points to have an edge.

• React to news and price changes quicker than quicksilver and have a speed advantage.

• Be a fundamentalist, analyse and examine every data that comes out of a company, and then buy only cheap at a reasonable price.

• Make global judgements about the economy and hit the right turning point for a general entry into the market to elegantly avoid analysing details of pea size.

• Buy the broader market with index funds, based on the idea that overall the stock market reflects the ongoing advance in the world and thus stock indices are doing well longterm.

• Delegate the work of making investment decisions to a professional, who, because being a professional, should outsmart the market.

Most people adhere not only to a single pure form of these strategies. They rotate between them, they try different flavors of them, they mix things up, they even start an investment with one strategy and close it with another. Or they start trading and end up with an investment. But important here is, that the latter behaviors seem to have all good arguments. The former types of "investors" are in one sense rare - if conducting a statistical inquiry, most participants would think of themselves belonging to the smarter group and would find their reasons and reasoning of why and what they are doing among the latter strategies. That is why it is generally believed that investing in the stock market will make people wealthy.


Now let's consider a different view of the stock market, a table with six players.


In the middle we have Mr. Doe, the private investor, left to him sits Mr. Clever who is a professional fund manager and at the right of him is Mr. Smart, a professional money manager for individual clients. On the other side of the table we have Mr. Broker, Mr. Market-Maker and Mr. Company. They all are doing what the market does - they are exchanging stock shares and bank notes, putting them on the table and taking them away at times. Let us concentrate on the money only, after all the money is the only thing that counts. Neither has the table a hole through which money could vanish, nor does money rain onto it. All money put onto or withdrawn from the table has to go through the player's hands. Let's have a look at Mr. Broker first

Busy Mr. Broker only sells and always wins

He charges a fee for simply forwarding an order from Mr. Doe, Mr. Smart and Mr. Clever to someone else. All that without risk and pain, and after doing so he pockets the fee - he takes it from the table. He can't make a loss, so with a bunch of marketing tricks he animates everyone to give him as fast as possible a new order. Important here is, what he does with regard to the table. He never puts money onto it, he only takes money away.

Mr. Market-Maker is known to be in a good trading position

He is the one who takes the other side of a trade and makes a mostly riskless business with the spread, a difference between buy and sell price. Furthermore he has state of the art equipment, which he watches like a hawk all day in a big room with other's doing the same, hoping that many hawkish eyeballs are seeing more than single prey's ones. But that's not all, he is known to be in a strong trading position, too. He works for a big company with much money, which other traders fear, so he is able to drive prices up and down, enticing euphoric Doe into high prices and shaking out trembling Doe with a loss at low prices. He initiates breakouts, which Doe falsely interprets as signals. Doing so he himself buys low and sells high. Some badmouthing tongues even argue that Mr. Market-Maker makes money with illegal insider information, front running or stock pumping. Not enough with that, he is supposed to create up- and downgrades, something like home made news, just to influence supply and demand of a stock to force its price to a level where he can sell or buy with more profit or a smaller loss. Overall Mr. Market-Maker seldom makes a loss, on average, he always wins. To make it short, he too takes only away money from the table.

For Mr. Company the stock market is a real gold mine

He has a special seat, with a big sign above it, on which is written - on his side so that especially Mr. Doe can't see it - "capital source". The other side of this sign could be labelled "capital drain", but that would lower the mood, so it only says "welcome". Mr. Company comes to the table right away from the printing press, with a big chunk of newly created stock certificates - paper, which he dumps on the table while cashing in tons of money. Will he ever give this money back? Hehe, stupid question, no he won't. The alternative for him is to borrow money by emitting bonds, which he obviously thinks of being more expensive in this case than selling paper. After all in the bond market he would have to give back what he borrowed after paying interest for it.

In very few cases his company survives and prospers. Then - in the far distant future - it is expected to pay back something to the table. Mr. Company can ignore such an expectation for a long time or even for the whole lifetime of the company, there is no law requiring him to fulfil it. But he can do so by paying a marginal dividend or by buying directly back some shares from the table, preferably when stock prices are low. That looks good and may cost him no money at all, because there are some nice ways to offset such payments.


• First, while making these payments, he can do a secondary offering. Mr. Company simply comes back to the table and dumps again a chunk of paper on it. Sounds primitive? No problem, he can mask the operation a bit.

• He does it just a bit before or after the phase of payments, preferably when stock prices are high. Buying back low and dumping high is a profitable business on its own.

• Or he creates sort of options by printing the additional word "warrant" or "convertible" on the paper. That means that he starts two dumping actions, one now for the option paper and one later in the future for exchanging the option paper for the original paper, cashing in twice.

• Even better he splits off a part of his company, declares it being a new one and sells paper with a new company name printed on it.

• If he is lazy, he simply distributes paper with the old name to the employees of his company. He can pay smaller salaries this way. Employees get shares proportional to their importance, meaning that he gets the biggest share, because he considers himself of being most important. Instead of one big, many smaller chunks are now dumped on the table.


There is another rare and very special case how money comes back from Mr. Company, a cash paid take over. Another Mr. C arrives at the table and buys with real cash all paper of Mr. Company from Doe, Smart and Clever back. But usually this other Mr. C got the whole money from the table firsthand, so this way nothing really comes back.

Actually Mr. Company is supported by two other persons behind the scenes. Mr. Investment-Banker helps carrying Mr. Company's paper chunk to the table. With much trumpeting he praises its quality as an investment. If Doe, Clever and Smart are nonetheless skeptical, Mr. Market-Maker, with his many tricks, makes the new stock's price going up. Then Mr. Doe loses all doubts and shoves the tons of money over the table to Mr. Company. Mr. Investment-Banker's risk is that he projects too big a chunk of paper for the table, so that he has to push the missing tons of money to Mr. Company, but that happens rarely. Mostly Mr. Investment-Banker just gets his fixed percentage of the tons of money from Mr. Company. Seen as an entity both will of course always drain money from the table during the paper dumping action.

Mr. Company's second supporter, Mr. Venture-Capitalist, got beforehand his own chunk privately from Mr. Company in exchange for money, hoping that Mr. Company raises the seed and is invited by Mr. Investment-Banker to the table eventually. He may even get a chunk from Mr. Company later when the stock is already on stage, typically for a better than the price at the table. In both cases he hopes that he can sell his chunk for a profit, which may or may not come true, but at the table he will never do anything else than dumping his paper and raking in money.

So we have three gentleman at the table taking away money. Some do it gently but constantly, some more raid-like.

Finally Mr. TaxMan appears every now and then, grabbing some money from the table and out of the trouser pockets of the participants and grins. Of course he never puts money onto the table either.

What about Doe, Smart and Clever? Well, they are fighting for who has to put the least amount of money on the table to feed the other side. We know that Clever and Smart are acting on behalf of Doe. They get a riskless payment from Doe for this fight, so it is not really that important for them whether they lose more or less.

It looks as if poor Mr. Doe is the real loser in this game. Interestingly Mr. Doe has a different perception of this.

But I already made a nice gain in the stock market !?

This seems to be a paradox. Yet it is none. The table view of the stock market is a totalized one, a view which cares only for averages. Of course there can be many individual Does having made their profit in the market, but on average Doe is the big loser. There can be a market maker, who suffered a big loss, which he never recovered, because he went broke. Yes, there even can be a company caring for its shareholders buying back stock shares and paying dividends with every free cash it earns doing its business, not offsetting these payments with tricks Mr. Doe is not aware of.

A second point of confusion is what happens away from the table. Mr. Market-Maker or Mr. Broker may have to pay a hefty monthly bill for their equipment, salaries and rent, so that they only break even. Mr. Venture-Capitalist may enthusiastically invest in any nonsense idea he hears of, so that he overall makes a loss. Mr. Company may have the wrong concept, not enough talent or too much competition, causing him to burn all money and go broke. He may be a genius, resulting in ever growing earnings of his company. All that is not important for the table model of the stock market. Even a rising price of a paper on the table doesn't matter. It looks like Doe, Smart and Clever are winning in this case, but alas, high prices are only tempting Mr. Company to dump the next chunk of paper. The only question that counts, is

Does the money flow through a player's hand from or to the table ?

The futures market is called by many a zero-sum game, because for every contract traded, there is a buyer and a seller and what one wins must be paid by the other. There is the proposition that the stock market is a positive-sum game, because over a long term, let's say some decades, stock market indices went up. Well, the table model suggests that the opposite is true. For Doe, Smart and Clever it is a negative-sum game. How can that be? Over time problematic index stocks get replaced by fresh ones with brighter future perspectives, so indices are distorted. But the main reason is simply, that all the owners of stock own paper but not money. If they all wanted to exchange their paper into money to get what the ever rising indices promise, these indices would drop to zero immediately. The stock market is basically a pyramid scheme, which implodes eventually, sometimes self induced, sometimes triggered by external events. More often it implodes only partly for some stocks or temporarily and so that not all stocks recover. That may be one reason why all this is so hard to believe.

Back to the beginning to the more smarter strategies how to beat the market. Will they not allow you to make money in the stock market? Doe, Smart and Clever are essentially fighting for a positive piece of a negative cake. So you nearly have to be a wizard to succeed. At least you have to be very good in your niche. This innocent little sentence contains what the Visoracle considers to be

The first and most important secret to make money in the stock market

You are destined to lose. If you aim to be a wizard and turn your fate around, you have to have a niche, a specific system in which every part fits to every other. Every particle which doesn't fit, drastically lowers your chance of success. Amazingly you are yourself one particle of the system, your strategy must fit to your personal psychology, you must feel comfortable to follow it. It is possible to combine and refine above mentioned smart strategies, but never stop searching for the grain of sand that blocks the gear. Think about the tricks of Mr. Market-Maker, Mr. Broker and Mr. Company and design your private investment or trading system around their traps. You have to trade or invest not only wisely, you have to do it differently.

The red hot trading system and the proven safe investment strategy

for which you may have been searching so long, are exactly the wrong way. You have to avoid everything prefabricated or you are perfect food for the sharks out there. Using a published system out of the box will always put you in a predictable crowd. You may even be riding a Trojan horse, originally designed by one of your enemies. Moreover it will not really fit to you, and it probably has other grains of sand in the gear. But beware, just mixing popular trading or investment system elements crudely into another system, disregarding the traps, will only add some big stones to the grains of sand. A better idea is to let existing strategies inspire you. Have a look at their elements from the perspective of the sharks, combine fitting ones and think through the whole. Before the Visoracle wishes you good luck, which you will need for surviving in the stock market, let me emphasize here again: If playing a negative-sum game against sharks and random, you at least must not be predictable, as the mathematics of game theory shows. You have to create your own very personal and specific system.


Source: www.visoracle.com