Make Consistent Profits In Good And Bad Markets
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Successful traders and investors are not just born, although they can be manufactured with meticulous planning, hard work, and discipline.
Anybody can build a successful trading business if taught the right tools and mindset.
That’s what Dr. Van Tharp preaches in his book, Super Trader - Make Consistent Profits in Good and Bad Markets.
Van Tharp is a leading trading coach and the founder of Van Tharp Institute, which offers high-quality educational services for traders and investors around the globe.
Dr. Tharp has studied over 5000 successful traders, including the very best traders to develop a successful trading model that new traders can learn from.
So, what is the successful trading formula discovered by Van Tharp?
Tharp emphasizes a 5-step process for becoming a successful trader.
The process addresses the core areas of trading, including:
● human psychology
● Money management, and
● System development
Of Dr. Tharp’s 5 steps, 4 crucial steps come together for profitability during rising, falling, and sideways markets, while the 5th step focuses on other ideas to up your trading game.
New traders should do well if they get the first 4 steps right.
Unlike other trading coaches, Dr. Tharp highlights the importance of working on the personal side and is the first step to becoming a successful trader.
Dr. Tharp is a neuro-linguistic programming modeler. As an NLP modeler, he studies many people who excel in something, studies what they do in common, and then determines what beliefs, mental strategies, and mental states are required to perform each task.
Once armed with this information, he can teach those tasks to others and expect to get similar results. He finds talented people and makes sure that they learn and follow the basics.
Like all professions, trading also requires domain knowledge and an enormous amount of practice. Just like no one can become a successful brain surgeon overnight, no one can become a successful trader without putting in the required time and hard work.
According to Dr. Tharp, when it comes to trading, 100% of the trader’s success can be attributed to trading psychology. Most traders focus largely on system development, which is the easiest part, and get entangled in their psychological biases to generate poor or mediocre returns. Therefore it’s important to work on beliefs, mental states, and mental strategies before fixing the nuts and bolts of a trading system.
The emphasis on psychology is important because humans are emotional beings. They become emotional about losing, about getting their money back from the market, about not making as much money as the next trader, and so on. All these emotions generally have devastating effects.
Okay, now we know Dr Tharp thinks trading psychology is the single most important factor to be a successful trader, but how do we get it right?
Dr. Tharp addresses this part by taking the first step of “working on yourself”.
To get the psychology right, we must start by knowing ourselves and differentiate between our harmless, and harmful beliefs.
Remember, “you” will be responsible for whatever results you generate in trading. So, always look within yourself first and address the “You” factor.
To get the broader level of psychology right, we must shed some harmful beliefs like perfectionism, low confidence, and self-esteem and be generally comfortable with the failures and setbacks. Do whatever it takes to be a peak performer. Think progressively, trade responsibly, and persevere.
Keeping a check on your mental state and having a broad awareness of your psychology will support you to flawlessly follow your strategy.
The other parts of psychology are generally concerned with keeping the right attitude, taking personal responsibility for failures and successes, shedding all excuses, and practicing mindfulness.
Be your observer and be cognizant of the cause-and-effect relationship in your life and trading.
Most importantly, a good trader must shed the desire to be right all the time. Accept being wrong and life will become much easier as a trader.
In a nutshell, a trader, like most successful individuals, requires a calm and positive mindset.
Once we are aware of the right psychological traits, it’s time to get to the next step, which is “formulating a business plan”.
A business plan provides direction and should incorporate all aspects of your trading, including a contingency plan.
How will you manage a drawdown?
Or perhaps a global recession?
What about a pandemic?
Or maybe the prospect of losing your job.
Or what if we encounter yet another credit crunch?
Knowing that situations like these will happen should make you plan for their eventuality.
The following are important aspects highlighted by Dr Tharp, and he says all should be considered when building a trading plan: After all you are building a business not a hobby.
Most new traders however jump in without following a plan and pay the costs later. Fail to prepare, prepare to fail….
Next we look at step 3; Developing a trading system.
Each trader should have a trading system which is built upon their beliefs and psychology.
To be a successful trader, you must build that system.
The system should be built on excellent risk management, which Dr Tharp measures through the concept of ‘R Multiple’ and is ultimately a measure of risk and reward. One of my previous Van Tharp videos helps explain this concept in more detail.
The system must be aligned to your trading style, which is born from your mindset.
You must ask yourself, are you patient or impatient? Do you prefer to be active or passive? Do you seek value or momentum? Do you consider the news to be of relevance? Do you like to study price charts? Or are you more of a fundamentalist?
Including the aspects of importance to you, into a system, will help you to stick with it.
The strategy I preach in our group for example, is based on my own beliefs and mentality.
I consider myself to be patient, I prefer a more passive style. I rarely listen to the news and I look for momentum in both technical and fundamental aspects.
The system should be adaptable over a longer-term horizon and be able to deliver in trending or perhaps sideways moving markets.
Ultimately, the trading system must be measurable.
We should be able to measure historical and current performance.
Historical could be in the form of back testing, or your own personal trading history.
Current would be your own recent performance.
The historical data should provide validation of your theory, whereas current data will ensure you are staying on the right track, whilst providing a continual feedback loop into the system.
You may have heard the term ‘smart’, it’s a business concept often relating to projects. The concept can also me aligned to a trading system.
The system needs to have a specific repeatable approach.
It should always be measurable.
The targeted performance should be achievable, realistic, and be realized within a reasonable time horizon.
Try to devise your own system which fits within this framework, such an approach will aid confidence, discipline, and consistency, whilst turning what many see as a side hustle, into a viable business.
Next we look at step 4, position sizing.
Position sizing, as suggested by Dr Tharp is the defining factor between successful and unsuccessful traders.
Even if you are right a whopping 80% of the time, but you risk too small a percentage of your capital, your reward may not be worth your effort. Conversely, if you risk too much per position you could drawdown significantly.
To better demonstrate position size importance, let’s look at a recent study published by Bloomberg.
The experiment made use of 61 finance experts, each were presented with a virtual coin toss simulator and a starting account balance of $25.
They were told that the coin had a 60% chance of landing on heads and a 40% chance of landing on tails. They were allocated 30 minutes and would be given a cheque for their final balance, up to a maximum $250.
The results were surprising.
28% of the finance experts went bust, losing their $25.
5% were down but not quite losing all the $25.
31% were given a cheque of between $25 and $100.
15% gained between $100 to $200
And 22% managed to get the maximum payout of $250
Remember, these were all finance experts, they all participated in the same game with the odds in their favour, yet almost a third of them lost all their money.
The defining factor is simple, it is position size. The same game, the same odds, the same starting balance, the same time frame and the same level of knowledge, yet wildly different outcomes. This is why position size is so important, it can make the difference between being successful or unsuccessful by a wide margin, despite all other factors being equal.
So how do we calculate the optimum position size for a trading plan?
There are several metrics which need to be determined:
1) The average win rate
2) The average risk and reward ratio, and
3) The equity balance
The system I teach through our group, and detailed in my PDF, provides an average win rate of approximately 58%, and it has a risk to reward ratio of near 4 to 1.
Dr Tharp refers to these metrics as ‘expectancy’ and equates them into R multiples to determine position size.
Using both of these key expectancy metrics, provides me with an optimum position size of 16%.
Therefore a $100,000 equity balance would suggest a position size of $16,000.
Not forgetting my average stop loss which is near 10%, equating to a ‘likely’ risk per position of $1600, or 1.6% of equity.
My calculation is based on the Kelly Criterion formula which you can see more on in a previous video. You can also see more on Dr Tharp’s position sizing calculation in the previously mentioned video.
Dr Tharp reinforces his view on position sizing when he says:
“Your success as a trader has little to do with selecting the right investment or even having a great system. Instead, it has everything to do with the “how much” factor when you trade”.
Let’s return to the coin tossing experiment to really understand the importance of position sizing, in combination with random probability.
This spreadsheet has been designed to give potential performance data of a trading account, depending on the metrics we add.
Using the biased coin tossing example, we can add in the probability of landing on heads here, which was 60%.
Of the $25 starting balance lets assume we use $2.50 or 10% per toss.
We also assume that perhaps 200 coin tosses were made.
Our equity curve examples are shown here. Notice how one of the simulations, shown in red here, lost all of the $25 and more before returning to profit.
This shows that despite a positive bias (or edge) of 60%, if position size is too large you are at risk of losing your account equity, despite the longer-term probability of profit.
The final step discussed by Dr Tharp is self-evaluation.
Constantly monitor yourself and be completely aware of your emotions and mental state. Make sure you are sticking to your plan, know the rules, and always abide by them.
For those interested if you like the idea of a focused trading community, why not join my website, and learn from my personal strategy.
Thanks for watching and bye for now.