Dr Van Tharp - Expectancy Value & Position Sizing

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Dr Van Tharp. Author of Trade Your Way to Financial Freedom, and founder of the Van Tharp Institute.

Dr Tharp suggests that the elusive Holy Grail can be found surprisingly quickly, but it is different for every trader, and each will take a different path to reach their desired level of financial freedom.

We explore the book and uncover some important findings.

Dr Tharp Says;

“Almost every successful investor has realised the lesson of the holy grail metaphor, that success in markets comes from internal control”.

From Dr Tharp’s vast experience, he found two interesting facts.

1) Most successful market professionals achieved success by superior risk control and shielding against heavy losses. Their foundation of success is built on solid risk management.

2) Most successful speculators have a success rate of between 35 and 50%, not because they predict prices well, but because the returns on their winning trades far exceed their losing trades. They can be wrong more than they are right but still make considerable returns.

In both situations tremendous internal control is required.

Traders who dedicate themselves to developing self-control are the ones more likely to succeed. This Dr Tharp suggests is the first step toward trading success, and says:-

“The Holy Grail is not a magical trading system; it is an inner struggle. Once you’ve discovered that, and resolved the struggle, you can find a trading system that will work for you”.

The next step to creating a trading system is to complete a self-assessment.

List your strengths and weaknesses.

How will you react to a large draw down?

How much capital can you afford to lose?

What is your profit expectation and over what period?

How much time can you dedicate to trading and what time frame best suits your lifestyle?

In summary, anyone planning to trade, must plan to trade based on their own individual profile, including psychological traits and personal objectives.

Once determined, the foundation for developing a trading system is set.

Dr Tharp believes that only 20% of people that trade the markets have a system, and the majority of those rely on a selection of indicators. Very few of them however truly understand the concept behind the system they trade.

A system is a variation of qualifying criteria that need to be met before actioning a trade, whereas the concept describes the ‘why’ behind the system.

Market Wizard Tom Basso says;

“The more you understand the concept you are trading, how it might behave under all sorts of market conditions, the less historical testing you need to do”.

The 80% that do not have a system will likely have inconsistent results and will generally not be able to look at past trading results to optimise their performance. This is due to the subjectivity of selection process.

A portion of the 20% that do have a system, but do not understand the concept, may fall into some psychological difficulties during periods of drawdown, largely due to a lack of confidence and often leading to poor discipline thereafter.

The few that have a system and understand the concept, or the why, will be able to trade with confidence, maintain discipline, and therefore allow for their system of ‘positive expectancy’ to materialise.

No matter how good your risk management, your inner control, or your discipline, the key aspect to a profitable system is ‘Positive Expectancy’.

Dr Tharp provides a thorough explanation of positive expectancy and the importance it has to all traders.

We are initially presented with two systems, system 1 and system 2.

Each have the same amount of balls and each ball represents a trade.

The outcome of each trade is expressed as a multiple of R, with the following values.

But before we determine which system is the most profitable, let us look at how R is calculated.

Assuming we buy a stock at this point, and our overall position size is $1000.

We place a stop loss at a predetermined point, and this example equates to a risk of $100.

Therefore, one R equals $100.

If the value of your position increased to $1200, your reward would be $200 or two R.

With the calculation of R established, lets return to the two trading systems.

The total R of system one equates to ten or using our calculation above, $1000.

System two has a total R of two, or $200.

To determine the expectancy of each system we simply divide the total R by the number of trades, or in this example, balls.

Therefore, system one has an expectancy of 1.0, whereas system two has an expectancy of 0.2

So, for every dollar risked on system one you can expect to profit one dollar. For every dollar risked on system two you can expect to profit 20 cents.

On this information alone you would be correct in thinking that system one would be the most profitable, however there is another metric that needs to be considered, which Dr Tharp calls the ‘Opportunity Factor’.

If over a twelve-month period system one produced 50 opportunities, that would be 50 times an expectancy of 1.0, equalling $50.

System two however produced 500 opportunities, which would be 500 times an expectancy of 0.2 equalling $100.

Expectancy, as defined by Dr Tharp tells you how much you can expect to win on average per dollar risked. It would therefore be wise to look for a system with high expectancy and lots of opportunity.

Before we move on, let us understand why system one has a greater positive expectancy.

We can see the winning trades from each system were the same, both had one blue ball with a value of 10 R, and both had one green ball with a value of 5 R.

The key difference is that system two allowed for two losing trades of minus 5 R, whereas system one cut the same trades short at minus 1 R.

Reinforcing the popular message of ‘let your winners run and cut your losses short’.

The next vital component of any trading system is money management, and Dr Tharp gives the most importance to ‘position sizing’.

He says;-

“Money management is the part of your trading system that answers the question ‘how much?’

Before we look to answer the question ‘how much’ let us look at the impact of drawdowns and the combined importance of risk control with position sizing.

This snippet from the book shows the drawdown percentage, and the subsequent recovery percentage required to get back to breakeven.

Notice how a 10% drawdown only requires an 11.1% gain to get back to breakeven, whereas a 50% drawdown requires a 100% gain to get back to breakeven. This shows how losses work inversely against us if we allow them.

There are generally 3 aspects impacting on these drawdown percentages: -

One. The length of losing run or low strike rate.

Two. The level of expectancy calculated from R multiples.

And three. The position size in comparison to your overall account size.

Using system two which gave less positive expectancy but more opportunity, let us see how three different trading account balances changed, using different position sizes.

We can see here account one had an R value of 2%, or $200.

Account two had an R value of 5%, or $500. And account three had an R value of 10%, or $1000.

Each account started with a balance of $10,000, and other than position sizing, the same trading strategy was used.

The outcome of each trade came in this sequence.

We can see here account one saw a maximum drawdown of 26%, account two a 65% drawdown, and account three saw more than a 100% drawdown and would have blown up their trading account.

The same system but entirely different performance.

To give these numbers more perspective, here are the equity curves.