Tharp's Thoughts Weekly Newsletter (View On-Line)

• Article Back to Trading Basics with Tharp Think by Shannon Mante
• Trading Education Van Tharp Signature Peak Performance Training
• TradingTip Don’t Throw the Baby Out with the Bath Water, Part 3 by D.R. Barton, Jr.
• Correction Link to corrected April 2012 SQN® Report

Back to Trading Basics with Tharp Think

by Shannon Mante

If you’re going to trade, you have to know what you’re doing. Seems like a no-brainer, right? The problem is that most people who say they trade possess no more than a vague sense of what’s going on in the markets, or how the markets work, or what they want from the markets.

If that sounds like a sweeping assertion to you, just look back at the landscape of history. It’s strewn with economic disasters for which there’d been clear warning signs, but that most traders and investors still had no idea were coming. Many of these traders were professionals who probably believed they understood the markets. It wasn’t until their accounts crashed that they found out they really didn’t. They’d been trading blind.

Fortunately, there’s a safer and more lucrative path across the market landscape, but to see it, you have to take off the blindfold. That’s exactly what “Tharp Think” gives you the ability to do.

Tharp Think is a comprehensive set of concepts and principles that take the mystery out of trading by diverting your focus away from the old, dead-end ways of thinking about the markets and toward a deeper understanding that cuts to the heart of how consistently profitable trading really works.

Instead of encouraging you to search for “one great stock” or to simply buy and hold (buy what, hold until when?) with no real goals, Tharp Think gets you to focus on who you are as a trader and what motivates you; how to think about and manage risk; and how to build a winning trading system that coincides with your beliefs. Tharp Think doesn’t predict, but it does take a statistical approach to the markets.

The Psychology of Trading

Tharp Think starts with your personal psychology, because trading is entirely psychological. Van often says, “You do not trade the markets; you only trade your beliefs about the markets.” If you start trading a system before understanding the beliefs and mental states (like fear) that drive your behavior, you’ll make mistakes. You’ll break your own rules and sabotage yourself. You’ll make irrational decisions based on whims, and your trading will end up being inconsistent at best—disastrous at worst. If, on the other hand, you understand your own psychology, you’ll be able to clearly articulate your objectives, create a position sizing™ strategy that gets you to those objectives, and develop a system that fits you.

After researching thousands of traders over many years, Van has found four key psychological traits that top traders usually have in common.

1. They take complete personal responsibility for everything in their lives, including their trading.
2. They have a deep sense of commitment.
3. They tend to have a particular psychological “profile” (to find out more about psychological profiles, click here).
4. They actively work on their personal issues.

Your psychological profile reflects your general personality, much of which you’re born with, but the other traits can be developed. If you don’t have the prototypical trader profile but develop an intimate knowledge of how your own mind works, you’ll be better off as a trader than those who do have the profile but continue to stumble across the market landscape wearing their blindfolds. You’ll be able to see that landscape clearly and chart a purposeful course across it because you’ll have articulated clear objectives that fit you.

System Development

If you’re going to trade consistently, you need reliable, productive trading systems. Trading systems constitute a set of parameters and rules that guide your trades. Because your psychology is so integral to your trading, you will be able to best trade systems that reflect your beliefs. Even if a system works amazingly well for someone else, it may not necessarily work for you. If the rules of that system are based on beliefs you don’t share, you’ll never follow them, and if you don’t follow the rules of a system, your trading results will be haphazard and arbitrary. Professional traders aim for consistency.

Position Sizing™ Strategies and Risk

Tharp Think emphasizes the critical importance of position sizing strategies in meeting your objectives. Those objectives could focus on capital preservation or on taking a lot of risk and making a huge return. Very few people understand that no matter what your objectives happen to be, your position sizing™ strategies meet those objectives—not your trading system. Position sizing strategies answer the question, “how much?” throughout the life of a trade.

There are as many objectives as there are traders. Some traders may focus on minimizing risk—on not having drawdowns bigger than some percentage of their account value—while others may be out to make 1,000% or more per year. Still others might want a combination of both; they might, for example, aim for profits of 40% with drawdowns no bigger than 15%. Whatever the objectives, your position sizing™ strategy achieves them.

Considering how critical position sizing strategies are for successful trading, you’d think that every trader would focus on them, but the truth is, most individual traders and even many professional traders don’t think much about position sizing, if they’ve even heard of the term. They think that diversification, asset allocation, or a trading system is the key to market success, but as we’ve said, position sizing strategies are much more important. A great trading system can certainly make it easier for you to achieve your objectives, but you achieve those objectives primarily through effective position sizing strategies. In fact, an average trader using a Holy Grail system could devastate an account by neglecting position sizing strategies or using inappropriate ones.

The Fundamental Laws of Trading

Van believes there are three Golden Rules of Trading:

Never open a position without knowing exactly where you will exit that position;

Don’t open a position unless your potential reward is at least twice the size of the pre-determined risk;

Carry out those rules by cutting your losses short and letting your profits run.

If you understand these three concepts along with position sizing strategies, you should be able to effectively use any valid trading concept: fundamentals, band trading, trend following, mean reversal trading, etc.

Expectancy and SQN

How do you know if your system is effective? The answer is actually pretty simple: your system should show a positive expectancy.

You can define your gains and losses in terms of your initial risk, 1R. For example, if you exit a trade after earning triple the amount of your initial risk, your trade profited 3R. If you lose an amount equal to your initial risk, you lost 1R.

Once your system has generated a number of trades, you’ll have a series of R multiples that represent your profits and losses. This series of R multiples forms a distribution of results, and the mean of that distribution is the system’s expectancy. If the system’s expectancy is positive, it’s profitable; if it’s negative, it’s costing you money, and you should stop trading it right away.

Recently, Van developed a proprietary measure for trading system quality called the System Quality Number®, or SQN®, which measures the relationship between expectancy and the variability of results for a trading system’s R-multiple distribution. The better the SQN score for a given system, the easier it will be to use position sizing™ strategies to meet your trading objectives.

Treat Your Trading Like a Business!

Learning to trade is different from learning to ride a bike; it’s more like learning a profession. Unfortunately, most traders think they can just close their eyes, pick stocks, sit back and let the money roll in. But it doesn’t happen that way, and eventually, new traders figure that out—often painfully. Successful trading takes a tremendous amount of planning, skill and training. Essentially, your trading should be viewed as a business—because it IS a business. And if you want that business to be profitable, you need to understand the parts of your business, you need a good plan, and you need the discipline to follow that plan.

If you're looking for a quick and easy way to make money in the markets, even Tharp Think won’t help. There is no "silver bullet" solution to trading success. The best way to trade effectively is to learn and adopt Tharp Think principles, and that takes commitment, time and effort. Traders who learn Tharp Think and apply the principles in a disciplined way will be able to transform a hobby into a profitable business venture.

Tharp Think is the backbone for all of VTI's home study and workshop material, and if you’d like to learn more about it, you have many options. A good place to start is this in-depth overview of each Tharp Think concept.

About the Author: Shannon Mante is the Production Assistant at VTI, where he edits the newsletter and other publications. He also owns an amazing and prolific collection of rock band T-shirts. You may contact Shannon at "shannon" at "vantharp.com".

Trading Education

Workshops

We have two new workshops added to our line-up!

1. Forex Trading. This is the three-day version. Last year, our one-day version sold out, and we had to create a waiting list.
2. We've added a new Tharp Think event. This is a one-day with Van Tharp for only $299.00

The rest of the line-up consists of our time-tested favorites. Click on the title of the workshop below to find out more.

To see our full workshop schedule, including dates, prices and location, click here.

Trading Tip

ETPs—Don’t Throw the Baby Out with the Bath Water, Part 3

by D.R. Barton, Jr.

Today we’re going to wrap up our series on the world’s most popular funds. As the title of the series implies, these funds have a lot going for them and almost every institution, hedge fund and serious trader I know uses them in some way, shape or form. But nothing is perfect, and this series was written to point out a few potholes in what is generally a very useful road to travel!

Over the past couple of weeks, we’ve been discussing the pluses and minuses of Exchange Traded Products (ETPs) in the form of Exchange Traded Funds (ETFs) and Exchange Traded Notes (ETNs).

ETPs are so popular because they’re easy to trade, and represent baskets of stuff that people want to buy or sell. ETPs put together these baskets of stuff relatively inexpensively, allowing traders and investors to trade a particular geographic region, industry sector or even physical commodity with the click of a button in their normal stock brokerage account.

To recap, we’ve reviewed some of the quirks about ETPs that we have to understand in order to not get caught in rare traps, like paying a large premium for ETNs that have had share creation suspended. Despite their foibles, ETPs are incredibly useful as trading instruments in multiple time frames. We have seen that institutions as well as individual traders and investors agree: ETPs dominate any list of highest-volume stocks.

Last week, we looked at a case study of how one might express a concept from research or analysis into an actual trade using residential home builders as an example. The main tool we used was digging into the actual holdings of individual ETFs. This week, we’ll do a similar case study for crude oil, but with a different slant: we’ll look at the actual performance characteristics for several well-known energy ETFs, and some lesser-known ones as well.

Choosing ETPs: Pick the One That Trades Like the Underlying Instrument

For today’s example, let’s assume that through your research and analysis, you’ve decided that there is a high probability for a move up in the energy sector. Specifically, you think that crude oil could climb to new highs this year.

Let’s concentrate our efforts on evaluating the trading of individual ETPs rather than the underlying commodity (in this case, crude oil). To do that, we’ll need to first figure out the best ETPs to use in our comparison.

Energy ETPs offer a wide assortment of choices. There’s the tremendously popular Energy Select SPDR Fund (XLE), which is trading more than 14 million shares per day on average as this is being written. However, the XLE's basket is too broad; it contains the stocks of oil companies, natural gas companies and oil services companies. There are other broad-based energy ETPs too, but we want to concentrate on ETPs that trade most like crude oil. Going back to ETFdb.com, we find a commodity category called Oil & Gas, which lists 24 ETPs. Here is an abbreviated list of all that trade more than 10,000 shares a day on average.

View Larger Image

I’ve highlighted the five that look like good candidates in purple above. One disadvantage that all of the ETPs shares is that none of their share prices look like crude oil prices. As a contrast, the most popular gold ETF, the SPDR Gold Trust (GLD), is generally priced around 1/10th the price of an ounce of gold, so there is a clear relationship. This annoyance aside, let’s take a quick look at a comparison chart of the top two traded ETPs: USO and OIL.

USO and OIL vs. Crude

So how well do these two ETPs track the price of crude? Let’s look at USO first.

Crude more than tripled in price from early 2009 to the first quarter of 2011, gaining about 250%. If you got the timing right and bought USO at the bottom in 2009 and sold at the top in 2011, your position would have been up only about 100%. Your USO trade would have earned only 40% of the crude price move! Not a result you would want, even though USO is supposed to track crude oil prices.

How about the next most popular ETF, OIL? Let’s take a look at the same chart set.

Different ETP, but almost the same result. Of all the oil ETPs, DBO did a marginally better job than the others of capturing the long-term crude move, but still, it only returned 119% from trough to peak. We could show charts for all the ETPs listed above, but it’s the same basic chart and numbers as the USO or OIL trade.

All of the crude ETPs significantly lagged crude itself, and they all suffer from the same problem, which is that they all consist of the same underlying instrument: futures contracts. They also suffer from “roll risk,” or having to roll over the near-term futures contracts held into the next month or months out. When crude oil futures are in contango (meaning the months further out are priced higher than the month closest to settling), these ETPs constantly have to sell lower-priced assets and buy higher-priced ones—meaning they are basically forced to buy high and then sell low.

Does this mean you should avoid trading crude oil ETPs? It depends. If you’re looking to capture swing moves (from a few days to a few weeks) in the commodity, then ETPs do a very good job of matching near-term moves. If you have a much longer time horizon, then the problems suffered by ETPs make them a less desirable choice.

As always, I’d love to hear your comments and feedback. Send them to drbarton “at” vantharp.com.

Great Trading, D. R.

About the Author: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena. He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at "drbarton" at "vantharp.com".

Disclaimer

Correction

Correction: The SQN report in last week's newsletter contained errors. To see the corrected SQN article, click here.

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