By: Van K. Tharp, Ph.D. On: January 22, 2018 In: Expert Advice, Most Popular Comments: 0

In addition to leading the Van Tharp Institute, I consider my two other primary roles to be a modeler and a coach. Although I have a Ph.D. in psychology, I have an extensive background in Neurolinguistic Programming, which enables me to be a superb modeler. As a result, I have spent my entire career modeling various aspects of trading.

If you asked for ten key elements important to trading success, I would start out stating ten useful beliefs. Beliefs are how you filter reality. They are not necessarily true, but they may be true within a certain context. You might think that some beliefs are simple facts— such as, jumping off of a 20-story building will mean you go splat on the pavement below. That, however, is only true within a certain context— like here on earth. If you did that on the moon, you might not even hurt yourself. If you jumped off of a space station, you might go up instead of down. Thus, beliefs are filters to reality and they are typically useful within a particular context.

Beliefs That Will Change Your Trading Forever

In my book Trading Beyond the Matrix, I presented a series of 55 beliefs about the market that are really useful. I call them Tharp Think. As with all beliefs, they are not necessarily real or true, but if you turn them into personal beliefs, making them part of your neurology, then your chances of making money in the market will go up dramatically. We discussed how to make them part of your neurology in a prior issue (See: The Most Important Factor in Duplicating Your Success, Your Trading Edge, Jan/Feb 2017).

Here are five of the beliefs which if followed, could make you seem like a trading genius:

  • Before you enter into a trade, always know your initial risk. Your initial risk is defined by a stop order in the market at the price which tells you that you are wrong about the trade idea. I call that amount that you are willing to lose R. This belief forces you to define when you are wrong about the trade and it enables you to limit your risk in the trade.
  • Make sure when you enter a trade that your potential reward is at least three times the size of your initial risk (it could be twice as much, but I prefer three times.) When you use this approach and you have ten trade results—four +3R gains and six -1R losses, you will have made money. Your four winners would have made +12R and your six losers would have lost -6R. That net gain is +6R, which means you averaged +0.6R per trade—despite being wrong and losing money on 60% of the trades.
  • Understand that you achieve your objectives through your position sizing strategies, not through your trading system. A great system just makes it easier for you to achieve your objectives through position sizing. Even with an amazing system, you can still lose your entire account by risking too much on a trade and being wrong. No system wins 100% of the time, so too much risk could bankrupt you with one trade.
  • Only risk a small amount on each trade, say 1%. That means if you have $100,000 to trade, your risk per trade would be $1,000. If your initial risk stop is $5 away from your entry price, you could determine your position size of 200 units by dividing the $1,000 risk per trade by the $5 risk per unit. To open such a position, you might use a lot of your money but you are only willing to lose $1,000 of it.
  • If we combine the information in these four suggestions and you make ten trades per month, then you will be up about 6% at the end of the month. That is, you are up +6R after 10 trades and each R is equal to 1% of your equity. This is an approximate number because as your equity grows, so will the value of risking one percent.

These suggestions can be applied to make numerous different types of systems that work under different conditions.

If trading is that easy, then why don’t we all make a lot of money?

To answer this question, we need to add a few more useful beliefs.

  • Trading success requires as much preparation, work, and effort as any other profession. If making huge profits from trading were easy, big money wouldn’t let you play the game. You’d have to take many tests (probably requiring that you know things that have nothing to do with trading success), which few people could pass and those who did pass would end up working for big money. Because trading success is very hard, you are highly encouraged to play the trading game with your money. Just open up an account with a few mouse clicks, transfer some money in, and start trading.
  • The second reason that people don’t make a lot of money trading is ‘mistakes’. A mistake means that you don’t follow one of your written trading rules. If you don’t have any written trading rules, then basically everything you do could be called a mistake. Even discretion can be governed by written rules (i.e., how you determine if you have a 3 to 1 reward to risk ratio when you enter a trade). I discussed mistakes in a prior article (see Jul/Aug 2016 issue of Your Trading Edge). So, let’s say your trading efficiency is 70% (you make 3 mistakes every ten trades), which is pretty normal for most people. Let’s also say that each mistake costs you an average of 2R. Apply three such mistakes to the scenario in the first four suggestions above (where you were up +6R at the end of the month), now you also have -6R in mistakes. Your -6R in mistakes take your +6R gain for the month down to breakeven.
  • The obvious conclusion from this is — Most people can manufacture R just by eliminating their mistakes or becoming more efficient in their trading.

The next key reason that most people don’t make a lot of money in the markets is:

  • Traders don’t understand market types.

There are at least six different market types including:

  1. Bull quiet
  2. Bull volatile
  3. Sideways quiet
  4. Sideways volatile
  5. Bear quiet (very rare)
  6. Bear volatile

When you understand the idea of market types, then…

  • It is easy to design a good trading system that will work well in one particular market type, but it is insane to expect that same system to work well in all market types. We cover this topic extensively in my How To Develop Winning Trading System Most people believe that system development is very difficult—and it is the way that most traders approach the task. They tend to try and develop a system that works all the time. The whole system development process becomes much easier once you start designing systems to work well in just one market type, one set of market conditions.

Let’s take an example of a simple system that works well in a bull quiet market, the market type which we have had in the United States for some time now. One kind of system that works well in this kind of environment would involve selecting nicely trending candidates in the strongest market sectors. You buy them and simply hold them with a 25% trailing stop. This means that your initial risk is a 25% drop (but each position still only risks 1% of your portfolio). Whenever the stock makes a new closing high (or intraday high if you prefer), you change your stop to be 25% below that new high. It’s that simple and that system is a better alternative to buy and hold. It should keep you in a stock for a long time during a bull quiet market. I have seen gains larger than +30R from such a strategy.

But will that system make money in bear market? No, it won’t. Could you just reverse a good bull market system and use it in a bear market? You could, but bear markets are not mirror images of bull markets. Imagine a bear market where you find a $50 stock that’s going down and you short it with a 25% trailing buy stop. At $50, you would buy it if it rose to $62.50. This is the reverse version of the system mentioned above for a bull quiet market type. The first problem with this system should be obvious. The best the position can do as a short is go to zero and if it does, you can only make +4R. In a decent bull market, +10R gains or more are often possible from trend trades. Second, almost by definition, bear markets are volatile (even if it started out quietly). In a bear volatile market type, you can easily have short-term retracements that are bigger than 25% of the stock’s value—even on stocks that eventually go to zero. Thus, you might be stopped out of a short position with a loss in a bear market and you would never make your +4R maximum gain—even if you were ultimately correct about the stock going down to $0. So let me reiterate this last point: It’s insane to expect a system that works well in one market type to work well in all market types. I have a market type analysis that I perform each month to determine the current market type. I share this with my readers to make it easier for them to keep track.

You don’t have to be an intellectual genius to understand the principles I’ve suggested and how they can dramatically improve your trading. If you follow them carefully, however, you may seem like a trading genius. What is your reaction to that last statement? Does it seem like these are easy suggestions to follow? Try them and see the difference they make. Also, consider this question – why will most people never follow these suggestions to make themselves into trading geniuses?

 

Van K. Tharp, Ph.D., has written 11 books, each one making profound advances in the understanding of what creates trading success. His research and modeling work with successful traders has made his training programs among the most well-respected in the world. Take the short quiz he developed to learn your trading personality type and if you have the characteristics of a great trader. Go to www.TharpTraderTest.com. Dr. Tharp will be teaching three workshops in Sydney, March 2018. Go to www.vantharp.com for more details.