The following is an excerpt from Trading Beyond the Matrix by Dr. Van K Tharp, PhD
“That ’s another 1R* loser,” Van announced to the class as he drew the final marble from the bag. There was an audible groan from most students—but not from me. “Okay,” I thought, “maintain your composure. No matter what, do not smile. Smiling would be bad. Just think about dead cats or something.”
The 25 or so guys in the class were just like me—reasonably smart, decent people trying to transform themselves into world-class traders, and each was sacrificing the Saturday before Super Bowl Sunday as proof of dedication to the craft. I certainly didn’t want to alienate any of them, but Van ’s announcement meant I ’d just won the pot in a game designed to illustrate a critical trading concept. The pot was small, but the win proved I had made a major change in how I thought about trading. To me, the win meant that, in a class of smart, driven traders and in front of one of the top trading coaches in the world, I was the top dog that day.
It was February 2011 and I was attending a “Tharp Think” seminar in Cary, North Carolina, a small town just outside of Raleigh. For me, the seminar was an opportunity to celebrate the end of my I Just Made 130 Percent—and That Was Just the Beginning of the 9 best trading years ever—over a 130 percent gain—and to reinforce the concepts most responsible for getting me there.
My path to trading was anything but direct. After working briefly in information technology (IT) after high school, I went to college and received a liberal arts degree. When I graduated, I worked a couple of IT jobs until I found a home as an IT and management consultant at a Big Five accounting and consulting firm.
By this time it was 1998, and I had become fascinated with making money in the markets. It seemed incredible to me that millions of people could come together to find the “right” price for a company, and the people who were great at it could become as rich as Warren Buffett. The company I worked for gave me the opportunity to spend seven months in Germany. That was a great opportunity to lock myself in my small apartment and read everything on trading I could get my hands on, and maybe do a bit of trading myself.
Germany was a perfect place for me to focus on learning to trade. I didn’t speak the language and didn’t know anyone except the people I worked with, so I read in my spare time. First, I focused on fundamental analysis, reading books about how people like Warren Buffett, William O ’Neil, James O ’Shaughnessy, and David Dreman invested and identified companies worth buying. Next, I learned about technical analysis from Martin Pring, Stan Weinstein, and Trader Vic. Then I found options, reading the whole 800-page Options as a Strategic Investment, by Lawrence McMillan, as well as books by George Fontanills and others. I became fascinated with limited risk and the incredible complexity of trades I could create using options. Wow, I thought, these things are amazing. There is an option strategy for every possible situation, and look at the leverage! Woo-hoo!
I liked saving money and had managed to put away $20,000, so I started trading. Sometimes I ’d do some fundamental screening and then decide to buy a few stocks. Other times I ’d find momentum stocks and buy options that were expiring in a few months. I also subscribed to some newsletters and would pick and choose investments that sounded good to me, primarily looking for those I thought had the best chance of a significant return. In hindsight, I really didn’t have much of a trading strategy. There were no real entry criteria other than the caveman approach: me see, me like, me buy. There was no predefined exit point where I ’d admit I was wrong and get out, and I decided how much money to allocate to each position by gut feeling.
Unfortunately, I lost on more trades than I won, which confused me. After all, I ’d done my homework and learned tons about how great traders won in the market. I had good reasons for entering every trade. I should be winning much more money, I thought. When I talked to people at work, it sounded like they were making money—a lot of it. But why? I knew I ’d studied more than they had. When I talked to them, they didn’t know anything about the fundamentals, or Warren Buffett, or technical analysis, or cool option terms like “delta,” “theta,” and “gamma.” I understood gamma, for heaven ’s sake! How cool was that? I thought I was destined to make money.
Even though I lacked a trading system, the markets were excellent, and even though I was losing more money than I thought I should, I was still making money. By 2000, I ’d managed to build my starting capital into about $75,000 by saving a bit more from my day job and benefiting from what, in hindsight, was a fantastic market. My family never had much money—my clothes always seemed bargain-basement compared to my friends and the highlight of many family “vacations” consisted of visiting relatives—so $75,000 seemed like a small fortune to someone like me who was still in his twenties. I still felt I should be making more though, so I continued to read and learn, but, overall, I was proud of the little pile of money I ’d made. I ’d done it on my own, after all, which made it even more meaningful.
In late 2000, I read something on the Internet suggesting that to win in trading you needed to have the right psychology. This was an angle I hadn’t thought of—you needed the right psychology to be a good trader? Could this be true? I was skeptical. The guys at the office didn’t seem to give a hoot about psychology, and they were making money. I made money, and I was sure my psychology wasn’t special. Even so, I decided I would explore it before ruling it out. My introduction to trading psychology would come in the form of a book called Trade Your Way to Financial Freedom by Dr. Van K. Tharp. I didn’t know it at the time, but the date I ordered Dr. Tharp ’s book, in 2000, was within weeks of the end of one of the longest, most profitable bull markets in U.S. history. I was 30 years old and about to lose most of my net worth. I put the book on a shelf rather than read it so I could continue to focus on making money.
When the bear market began, I continued trading as I had the prior few years—I didn’t follow any real strategy, but I ’d read a ton and thought I understood enough to make money. I traded some on the short side, but my primary focus was long. The market had been going up for most of the last 20 years and the downturn in late 2000 seemed like just the buying opportunity I ’d read about, with “blood in the streets.” Some great stocks were now real bargains: Worldcom! Global Crossing! Earthlink! Puma Technologies! I bought them all.
I soon discovered the importance of applying the appropriate metaphor to the current market situation. Yes, there was “blood in the streets,” but the proper metaphor for the moment was something like “don ’t try to catch a falling knife” or “low stocks can always go lower” or “don ’t fight the tape.” Funny thing about trading metaphors: most of the “market experts” who quote them don ’t give you any truly helpful advice on when to apply one versus another. The metaphors always sound wise when someone says them, though, don ’t they?
Over the next two years, the Su0026amp;P 500 plunged more than 40 percent and, in a show of solidarity, the vast majority of my money went down the drain with it. I was angry and disgusted with my failure and determined not to lose all my marbles again.
But how should I move forward? Clearly needed to change what I was doing, but what was the best way to do that? I thought I ’d already read the right books, so what experts could I trust to help me? Was there a different way of doing things—a different trading metaphor—I should be using? My trust in the traditional “experts” had diminished in lockstep with my account value. Maybe that book by Dr. Tharp was worth a read now.
I love to learn. Any time an author can add some knowledge to my repertoire, I ’m always excited. Consequently, I devoured Trade Your Way to Financial Freedom, a book that seemed to be about more than just psychology. The psychological parts struck me (at the time) as being a little too intangible to be relevant to trading. I wanted to make money, after all, and still wasn’t convinced that psychology was the key to making money in the markets.
Dr. Tharp clearly understood how I thought about trading, and as a result, the book grabbed me immediately. I read about “Holy Grail” systems, as Dr. Tharp refers to them—“perfect” systems that focus on picking the right stocks * and on when to enter the market, and that work whether the market is bullish, bearish, or neutral—and realized that I ’d been spending my time looking for one myself. I didn’t want to think about having different systems to enter the market—one when the market was bullish, one when the market was neutral, and one when the market was bearish. What a pain that would be! Wouldn ’t it just be easier to use one system for all markets rather than a different one for each type? Not only that, but also having one system per market type would mean I ’d need a way to determine the market type. In other words, this approach would require me to do more work.
*Van’s Note: This is actually other peoples’ definition. My definition of a Holy Grail system is
one that produces an SQN score over 7 for a particular market type.
Unfortunately, Dr. Tharp said that expecting a system to work in all types of markets was insanity. Ugh, I thought, implementing this guy’s ideas is going to take time and effort. My brain was already trying to find a way out of putting in the work his suggestions required. In hindsight, I see that I had no concept of the amount of work required to implement all his ideas. Double-ugh.
He also said that making a lot of money in the markets would not be fast or easy. I don’t like this guy, I thought. Although many of his ideas made sense, I really didn’t want anyone telling me how hard trading would be. After all, I’d read tons of books and done more work than most people. The work should be hard for them, those people who hadn’t done as much work as I had, but not for me. I wasn’t done with the first chapter yet, and this guy was already frustrating me. Just give me the bullet-point list of how to make money!
Still, I kept reading, and Dr. Tharp kept pressing my psychological buttons. He said there was very little chance anyone could give me a system I could use to make a lot of money in the market. He didn’t say the system couldn’t be built, only that if someone gave it to me it probably wouldn’t work for me. I started thinking Dr. Tharp was off his rocker. He seemed to be saying that if someone gave me a perfectly good system I ’d screw it up somehow. How could he make such a broad statement? I ’m smart, disciplined, and successful in my nontrading career, so he must have been talking about other people, not me (it would take me nearly a decade to realize he was right, and my inability to find a system that consistently worked well for me was a direct result of continuing to look to others for the perfect system).
So, why did I keep reading? I guess because many of the ideas did resonate with me. For example, Dr. Tharp said that winning traders often lose on more trades than they win—maybe winning only 35 percent of the time. Making money while winning less than 50 percent of my trades was exactly what I experienced in the late 1990s, and Dr. Tharp clearly understood the phenomenon. He discussed having a positive expectancy, or mathematical expectation of profits, and provided a simple formula to calculate it. Because losing is a part of the game, he discussed the importance of learning how to accept losses as part of trading and not making them worse by failing to admit when you are wrong on a trade. All of these ideas resonated with me.
Dr. Tharp also talked about the importance of taking responsibility for your results. In other words, if you decide to trade based on newsletter recommendations, as I did, and lose money, it is your fault, not the newsletter ’s fault. You chose the newsletter, and you chose to invest based on its recommendations. You decided to trust the newsletter ’s published results, showing they won 75 percent of the time. You decided not to paper-trade the recommendations for six months to confirm the results before starting to trade real money. You didn’t stop to find at least one independent source who had confirmed the newsletter ’s track record before trading. You, you, you!
While it was frustrating to take full responsibility for my losses, I knew it was the right way to view the situation. Have you ever blamed someone else for your poor trading results? If so, go ahead and try the taking responsibility exercise above with any external sources you counted on for trading advice, and see if you can fi gure out how you might have caused the disaster you blamed on them. Your broker told you to buy that stock, and you trusted him? It was your choice. Your money manager vanished with $1 million, your entire net worth? You didn’t do enough background checks on him because you didn’t consider the possibility that he might steal your money. You also chose not to split your money into three equal parts and give each part to a different money manager. Try the it wasn’t my fault game yourself next time you lose money. If you can ’t trace the results back to you, ask other people to help you, and tell them to be relentless.
Yes, it is, of course, true that many events are unlikely and that none of us has the time to explore every option for every decision. If we did, nothing would get done. But what about the big decisions, like where to invest your entire net worth, or whether to start trading with real money with a system you haven ’t paper traded? Aren ’t these decisions big enough to warrant some contingency planning?
When you stop and really think about it, how could I fix something if I didn’t think that allowing it to happen was my responsibility? Is it possible I didn’t do all the checking I should have on I Just Made 130 Percent—and That Was Just the Beginning 15 that newsletter because I didn’t know whom to talk to? Or maybe I didn’t independently validate the results because I didn’t know how and didn’t think about paying some college kid $500 to do it for me because that would be too expensive? Maybe I didn’t want to wait to make money and thought about all the money I wouldn’t be making if I paper-traded the system for six months?
Chances are you ’re at least somewhat like me and avoided (yes, avoided!) taking a few prudent actions that could have saved you a pile of money. Test yourself; if you aren’t able to come up with 5 to 10 things you could have done differently, you ’re not trying hard enough. More importantly, you’re likely to continue struggling with trading in the future.
As I continued reading, the book talked about a number of psychological biases that cause most people to do exactly the wrong things in the market. For example, we don ’t have the mental capacity to take in all the information the market makes available, so we generalize, delete, or distort the information. Consequently, if you believe that trend-following systems don ’t work, you probably feel content to ignore information about how to trade them. Alakazam! You ’ve just seen a judgmental bias in action. You generalized (trend-following systems don ’t work), and as a result you were able to massively cut down the amount of trading-related information you have to pay attention to. But was your generalization correct?
Another bias is the so-called lotto bias, which describes the confidence people develop about their chances of success when they have some control over the information necessary to win. For example, many traders become irrationally confident they will win because they are using a group of indicators—moving averages and oscillators, for example—to tell them when to enter the market. Other people, like me, feel the same irrational sense of control and chances for success because they get to choose which of the newsletter’s recommendations to buy. Ugh.
As I read on about the other biases and how they affect traders, I was hooked. Dr. Tharp gave compelling examples, and I could see my own actions in many of the behaviors he discussed. The book said that most people think of a trading system as the answer to the question: When do I enter the trade? At the time, I couldn’t have agreed more; I was totally focused on market entry. Unfortunately, when to enter is the least important part of a trading system. I ’ve heard Dr. Tharp and Linda Raschke, another market wizard, say they have tested random-entry trading systems that make money, albeit not enough to be easily tradable. These systems enter the market on a coin toss and use good exits to accept losses and take profits, and they seem to confirm the relative importance traders should ascribe to exits, not entries.
Even with all of the things that resonated with me, though, there were plenty of things that didn’t, at least not immediately. For example, Dr. Tharp argued that a good trading system would have 10 parts, the most important of which is objectives. Objectives? Seriously? I want to make as much money as humanly possible, that ’s my objective! Anything less would limit my potential, wouldn’t it? What crazy person would want to limit how much money he could make in any year? Unfortunately for my ego, I discovered as I continued reading that the book made a good case for determining your objectives before designing or trading a system. Darn, I thought. This Tharp guy is really starting to annoy me.
I found a number of the book ’s concepts provocative, but by far the most potent for me was the power of position sizing strategies. A position sizing strategy is simply the part of the trading system that answers the question, “How much will I risk on this trade?” Sounds simple, doesn’t it? It is, and it isn’t.
What if I told you I would put you into a fully automated trading system with the following characteristics: It wins 35 percent of its trades, and when it wins, the winning trades are, on average, three times the size of the losers? What if I also told you I had been trading the system for 25 people, each in a separate account, for the past 10 years? While some years were better than others and the system was in negative territory for at least a portion of every year, all of the last 10 years were profitable for every account. All of the accounts were with the same broker, started with $100,000 and had exactly the same commission structure, and the system only traded liquid markets. Sound interesting?
Here ’s the twist: While the system made money every year, the percent-gain realized was very different for each of the 25 accounts The gains ranged from 4 to 95 percent gain in the most recent year and from 2 to 72 percent the previous year. The previous eight years showed similarly 17 diverse performance across accounts. The performance was independently validated by a credible accounting firm and found to be completely accurate.
But how could this be? Remember, this is a fully automated system—the trades were entered and exited automatically, everyone started with the same equity, took exactly the same trades, and exited at the same time. Small differences in percentage gains across accounts could be accounted for based on slippage, but slippage couldn’t come close to causing this range of differences. What was going on here, you ask?
The answer is position sizing strategies. Each trade was exactly the same for each account—with the exception of how much money was risked on each trade. The owner of account one risked 0.5 percent of account equity per trade, had the smallest drawdowns and the smallest gains every year; the account owner ’s objective was to minimize drawdowns. The owner of account 25 used a more complex position sizing strategy, which risked more and more money as the account equity moved further into positive territory. Account 25 also experienced significant drawdowns, the largest being 65 percent. This account owner ’s objective was to make at least 50 percent per year, even if it meant a maximum drawdown of up to 75 percent. And because he was willing to suffer the drawdowns, most years he made at least 50 percent.
These sample accounts show just two possible methods of using position sizing strategies to achieve objectives. There are a number of other position sizing methodologies that could be combined to build thousands of strategies. For example, most traders recognize the importance of volatility in markets, and, while not universally the case, many traders feel that more volatility equals more risk. So what if you took smaller position sizes when the market displayed significantly higher-than-normal volatility (e.g., double the average true range measured over the past 90 days)? Or what if you combined position sizing strategies by risking 1 percent of account equity except when the volatility goes above some predetermined threshold? Each of thousands of position sizing possibilities could result in a different ending equity level despite taking exactly the same trades.
The variability in results sounds too incredible to be true, you say? I ’m right there with you—or at least I was until I did some independent research, which seemed to support the case that position sizing was capable of making this kind of difference in returns. I also used some software to test the impact of position sizing strategies on my own, which cemented the case for me.
But don ’t take my word for it—there ’s an easy way for you to test it yourself, and it won ’t cost you more than $20. Remember the marble game I mentioned at the start of this chapter? The marble game is nothing more than an example of using position sizing to achieve your objectives (e.g., one objective being to win the game at all costs, even if it means going bankrupt). Here is how you play:
*If you do the math, this system produces 65R in losing trades and 122R in winning trades. However, there are 65 losing marbles and only 35 winning marbles. Thus, you have a 65 percent chance of losing on a given draw compared with a 35 percent chance of winning. But if you add up all the wins and losses, it totals (122R – 65R = 57R) + 57R. Expectancy is the average R-value, which in this case is 57R/100, or 0.57R. Thus, on average, you ’ll make 0.57R per trade in this system.
Remember—the point of the game is to help you understand the importance of position sizing strategies. Every player gets exactly the same trades (i.e., marbles); the only difference is the size of each bet. That being said, the marble distribution above is actually similar to the trade distribution of many good trend-following systems (i.e., you lose 65 percent of the time, but, if you use an appropriate position sizing strategy, the size of your winners makes the system very profitable).
Yes, Dr. Tharp ’s book was an eye-opener for me, so you might think I started using what I learned from the book to my advantage right away, and to some degree I did. Over the following years, I continued to trade lightly, still somewhat shell-shocked from my earlier losses. I continued to learn and test systems, but never to the point where I was comfortable enough to trade them with real money. I kept reading books by Dr. Tharp and began accepting some concepts I rejected earlier, like the importance of objectives. I continued to take some newsletter trades; some won, some lost. On balance, I probably broke even. Regardless, my trades were too small to make a significant impact on my bottom line.
Too small, that is, until 2004. Late that year I decided I would be comfortable risking some money on a “proven” mechanical system. I searched the Internet and found a system designer who sold me two complementary black-box systems—that is, systems whose underlying logic is hidden, so that you can only see the trades it spits out—for about $3,000. The back-tested results were excellent. Collectively, with a position size of 1.5 percent of equity on each trade, the two systems returned better than 50 percent per year with a worst-case drawdown under 35 percent over a 25-year period, and the results were reasonably consistent across years. I removed myself completely from the trading equation by finding a Commodity Trading Advisor (CTA) to trade the systems on my behalf and waited for the money to roll in.
About two years later, I closed the account after losing 50 percent of my money. Ugh. Again, I thought I ’d made good decisions, carefully researching the systems before buying them, and allowing someone else to trade them mechanically on my behalf. Unfortunately, it appears the system designer curve-fi ted the results.
Curve-fitting means you optimize the system on historical data until you get results that look fantastic. The problem with curve-fitted systems is that they tend not to do so well in the future. This was another lesson learned the hard way: if you don ’t know how the system has tested, there is a good chance it wasn’t confirmed effectively and the results aren’t worth the paper they ’re printed on. For the next few years, I did very little trading, choosing instead to watch the markets and continue reading and learning on my own again.
In early 2010—almost 10 years after buying Trade Your Way to Financial Freedom—I thought I might be ready to try trading again on my own. I was still scared of losing but believed that if I kept my position sizes relatively small, I could stop trading and limit my losses. To promote discipline, I created a few simple rules for myself:
This set of rules was not even close to what Van would consider a comprehensive trading plan, but it helped me do enough things right to capitalize on some big, very profitable trends.
I waited until May to take my first trade of the year, a natural gas bounce-off-support trade. The trend was strong, and I added to my position as natural gas moved up, while locking in profit by
moving up my stops as the trade went in my favor. The trade ended up being a 5R winner—in other words, I made about five times what I risked on the trade. If I ’d lost on this trade, I ’m not sure I would have been confident enough to keep trading, which is very significant when you consider my results for the year.
While I still lost more trades than I won—I think I only won about 30 percent of my trades—the winners were big, and I did well. As of December 31, my account value was up more than 130 percent, and I never experienced a drawdown greater than 20 percent. I was excited—so much so that I took screenshots of my account equity each time I reached a new equity high, almost as if I needed visual evidence that my results were real. As much as I wanted to have a year where I made 100 percent+, I wasn’t sure I could really do it.
Despite the success, I made tons of mistakes that cost me some very significant money. My guess is that I probably would have made at least 180 percent, probably more, without the errors. For example, in December, my wife gave birth to our first child, and I didn’t follow my positions as closely as I should have while I was with her in the hospital. I had my stops in place, but I wasn’t able to exit on intuition as I did at other times when I saw the market wasn’t moving quickly in my direction.
Also, I held too many positions—sometimes as many as 15 at once—and it turned out that some of them were correlated. After experiencing a drawdown as a result of correlations, I subscribed to a correlation service. The service provided a matrix of correlations, and I was more careful only to take positions with little to no correlation over the most recent 1-, 5- and 10-year periods. Unfortunately, I learned the hard way that correlations on any given day don ’t really care about historical correlations over 1-, 5-, and 10-year periods—another lesson with a high price tag. Big ouch!
Also, as I continued to trade, I noticed that my criteria for taking trades became more lax. Sure, I still looked for breakouts and bounces off support, but I seemed to get less picky about only taking the trades that looked the strongest. I became more impulsive.
I found I really wanted to be in trades because I was afraid I might miss a big move if I wasn’t in the market, and missing a big move would be painful. As a result, I had far more losing trades later in the year and forfeited profits as a result.
I also wasn’t very methodical about keeping a trading log and reviewing it to find and address my mistakes. I looked over my trades and noted some of my mistakes, but I didn’t set aside the time I needed to do a good job of it. If I had, I have little doubt I would have avoided at least some losses.
I also risked way too much per position early in the year. After a couple of months risking about 2 percent of account equity per trade, the account fluctuations told me I was risking too much. I cut back to 1.5 percent and later to 1.25 percent. These reduced risk levels still allowed me to have significant gains, but, more importantly, they reduced my daily account fluctuations and improved my peace of mind. I find it funny now, but before 2010, I remember thinking, “How will I ever make any real money if I only risk 2 percent of equity per trade?” If this statement rings true to you, play the marble game risking 2 percent of equity per trade, and then do it again risking 10 percent of equity per trade, and prepare to be enlightened.
I firmly believe that looking for good reward-to-risk trades and using a reasonable position sizing method were the most important factors in my results. The scientist in me is the first to admit that there was some luck involved on individual trades—but it would be hard to make the case that luck was a major factor on the 100+ trades I made over seven months. Even with all of my mistakes, I used enough of Dr. Tharp ’s principles to knock the cover off the ball. So, what now? I ’ve stopped trading and am going to take some time—at least a year—to focus on becoming a more efficient trader. As Dr. Tharp defines the term, efficiency means reducing the number of mistakes you make to the point where they have little impact on your results.
I’ve mentioned a number of things I plan on improving, but I haven ’t talked about my psychology. You may recall my views about the value of “trading psychology”; at the start, I was doubtful that psychology was important, let alone a key to trading success. Dr. Tharp wrote about the importance of a trader ’s psychology in Trade Your Way to Financial Freedom and other books, but it didn’t completely resonate with me. After all, why would psychology matter if I had a good plan and stuck to it? Wouldn ’t that take psychology out of play?
It took about 10 years, but I ’ve come to realize the answer is probably “no.” Psychology was the reason I made those mistakes in 2010. Psychology is the reason I haven ’t invested more time in pursuing my dream of becoming a full-time trader; I was scared of walking away from a lucrative day job and of what my family would think. And psychology was responsible for the mental chatter, uncertainty, and discomfort I felt as I traded, and I ’m sure it cost me in terms of returns. So, as with other Tharp Think concepts I initially resisted, I ’ve come to believe that psychology is a big factor in becoming a consistently successful trader, and I ’m planning on spending the next few years getting mine where it needs to be.