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

• Article What a Frog Can Teach, by Ken Long
• Trading Education Learn to Trade Forex
• TradingTip Risk-On & Risk-Off Trading—The New Normal, Part 2, by D.R. Barton, Jr.

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What a Frog Can Teach

by Ken Long

When I was seven years old, my family moved into a new housing subdivision that was still under construction and set in the middle of some woods. I spent most of my summer there in a little plywood clubhouse built from scrap lumber, immersed in a world of Marvel comic books, baseball cards and frogs from a little nearby pond. With patience and quickness, I could catch the frogs from that pond by hand all day long—except for the fabled Daddy Longlegs. In my memory, he was a giant frog, as big as both my hands, who evaded my efforts to catch him thanks to his constant vigilance and powerful legs.

I remember that frog and his jumpy ways to this day. No matter how carefully I sneaked up on him, he would always make a powerful move at just the right moment and evade my grasp. I could never figure out when or in which direction he was going to jump next. I only knew that when he did jump, it would be fast and far. Even though I never got my hands on him, I learned a lot about stalking, focus, commitment and patience from that frog.

A Trading System Inspired by a Frog

About a year and a half ago, I was in the process of creating a new trading system to meet a new set of requirements. As the system started forming in my head, my memories of Daddy Longlegs actually became the inspiration for how it would work. Here are the requirements I wanted the system to meet:

• Frequency—It could find trades every day. This was as much about the effect of frequency on trading capital as it was about the improvement process and reaching higher levels of performance through regular practice.
• Performance—It could produce at least .5R per day on average (i.e., 100R per year for 200 trading days) and have an SQN score of three or better.
• Simplicity—It would require little to no trading experience or chart-reading skills and be straightforward enough that trading novices could apply its rules successfully.
• Flexibility—It could be used with stocks and various other market instruments. While I primarily trade index-based ETFs and large cap stocks, I wanted this system’s logic to work in other trading arenas eventually as well.
• Calmness—Optimally, the system’s simple rules would leave little question as to how to enter or exit a trade. Also, it would hold no positions overnight and have none of the related risk.

Was Such a System Possible?

It probably seems like bundling all of these requirements into one system would be a difficult task, but a couple of separate pieces of research helped me accomplish it; they form the basis for what I started calling the Frog trading strategy.

The first piece of research that informed my design process involved Claude Shannon's work with information theory. By discovering ways of differentiating signal from noise in a communication channel, Shannon made the digital information age possible. I believe the market speaks in terms of price, so it was natural for me to think about how Shannon’s work could be applied to distinguishing between signal and noise in a stream of price information from the market.

Next, I came across various pieces of research that discussed a method that very often identified when the high or the low of the day was made. It occurred to me that if we could observe the price action and direction in the morning session and we saw price moving away from what could be the high or low of the day, it might be possible to place a trade with a favorable reward-to-risk ratio.

This is where the frog idea jumped into my head. What made Daddy Longlegs such an exceptional frog was the fact that he always made powerful and reliable jumps. I believed I was looking for trade targets that made significant and consistent moves compared to their peers.

But were consistent trade targets knowable? I wondered and kept thinking about it. If I could figure out how far the price of a stock would move after making what looked like the potential high or low of the day, I could be ready with an entry, an initial stop and a target price that gave me an acceptable risk-to-reward ratio. By applying statistics to describe past moves, I figured I could evolve one of my current price measurements into a new measurement of movement and consistency.

Daddy Longlegs provided more inspiration for the system. He didn't remember who I was from day to day; he was a creature who surely lived in the now. Similarly, the Frog trading strategy requires no memory or serious study of the previous day’s price movements. The only information required to trade the Frog is the calculation of the distance that the price is likely going to move today.

My Real Goal

All of these memories and ideas came to me as I thought about designing a trading system that I could teach my wife and kids to use with little to no supervision on my part. None of them had traded before but were willing to learn after seeing me trade for years.

The first trainee was my wife. The system was so simple that it took about twenty minutes and a sheet of paper for me to teach it to her, and she’s traded it on and off for a number of months now. She's primarily a full-time mom, wife and friend, so she trades it only on days when it fits with her busy schedule; even still, the Frog has generated an SQN score of nearly 3 for her. She’s even taught the system to some of her friends, and now they trade it too. Her experiences trading the Frog satisfied me that the system performs acceptably, so next, I’ll be teaching it to my son, who is about to come home from college for the summer.

The Frog’s Effect

Designing and trading the Frog has also revolutionized the way I approach intraday trading across a variety of styles, and it’s had an impact on a number of the traders in my day trading chat room. Some have modified it and others have adapted elements of the Frog into their existing trading systems. It seems to be great because it offers the following advantages:

• Daily setups and trades
• Simple rules
• No overnight risk
• Unbiased for daily direction
• Performs best when the market moves sharply
• Little to no preparation time
• Consistent performance

How to Learn the Frog

I have already been teaching the Frog system at my swing and day trading workshops, but it’s a little different from all of my other systems. Most of the systems I’ve developed and traded are better suited for traders with some market experience; I wouldn’t teach them to inexperienced traders like my wife or kids as a first try. The Frog trading system, on the other hand, is well-suited for people who may not know how to trade but would like to learn how. Of course, this isn’t to say that the Frog isn’t valuable for seasoned traders, as well; there are plenty of people with market experience who would like to run a simple and consistent system with all of the benefits mentioned above.

The Frog’s characteristics make it relatively simple to trade, though I would never say that trading any system is easy; psychology might make “easy trading” nearly impossible. The Frog has a slightly better than 50/50 win rate, but the winning trades are larger than the losing trades by a fair margin, so the system produces a strong SQN score. A very conservative position sizing™ strategy can generate great results. For instance, you could risk ½% equity per trade and generate something like a 60% return in a year through the effects of consistent results and compounding (correction: the original article erroneously provided a figure of ¼% equity per trade).

For the people committed enough to trade the Frog system well, we’ve created a boot camp. Students at the boot camp will use a simulated trading platform to trade the Frog system over more than one hundred days of historical price data.

My experience with simulators in the Army has made me a firm believer in their ability to accelerate and strengthen the adult learning process. At the boot camp, your learning process will progress in the presence of other learners and with the support of an experienced coach. This intense, highly focused, repetitive experience will give you a huge jump ahead on trading the system when you get back home.

After three days at the boot camp, students will have executed more than one hundred Frog trades. At that point, you’ll 1) have confidence in your ability to trade the system and 2) know how to trade it under numerous varied conditions. You’ll know what you can do to really take charge of your trading and make decent money, week after week.

For more information or to enroll, click here.

About the Author: Ken Long is a retired Lieutenant Colonel in the U.S. Army with a D.M. in Organizational Behavior. He is a proud father of three, a husband, teacher, student, martial artist, and an active trader. Ken is also a dynamic workshop instructor for the Van Tharp Institute.

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Trading Tip

Risk-On & Risk-Off Trading—The New Normal

Part 2

by D.R. Barton, Jr.

Imagine that you and I are in a relatively small boat with 50 of our closest friends in the Caribbean Sea. The water is calm and clear. Through the turquoise blue below us, we can easily see all the way to the sandy bottom.

Suddenly, a passenger yells out that a sunken treasure lies just off port side, whereupon half the people hurry over to the wrong side of the boat—because, let’s face it, few landlubbers really remember which side is port and which side is starboard (port is the left side of the boat. Memory hint: “Port” and “left” both have four letters).

Seconds later, almost everyone has identified the correct side of the boat, and all are leaning over the edge in an effort to catch a glimpse of the treasure. As the last stragglers pile over to port side, the smallish craft does what you would expect—it starts to tip over. At this point, one of two things will happen: a significant mass of people will move quickly back to the middle of the boat so that it can find its proper center, or everyone, bound and determined to find the treasure at the bottom of the sea, will stay put, and the boat will tip all the way over.

Welcome to the world of “risk-on, risk-off” trading.

Last week, we looked into the basics of the “risk-on, risk-off” environment that has defined our increasingly volatile financial markets over the past decade (click here to read last week's article). Today, I’d like to share some insights on why “risk-on, risk-off” investing has become so prevalent. The answer is something you probably already knew, but the details may really surprise you.

I Know Everybody Is On the Same Side of the Boat—But I Don’t Want to Get Fired

Jeremy Grantham of GMO, a global investment management firm, writes a quarterly letter that is always a treat to read, and his most recent opus is no exception. In the following excerpt, Mr. Grantham explains why almost all professional investors keep rushing from one side of the “risk-on, risk-off” boat to the other, as well as the degree of the phenomenon:

The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business we are all agents, managing other peoples’ money. The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority “go with the flow,” either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price. There are many other inefficiencies in market pricing, but this is by far the largest. It explains the discrepancy between a remarkably volatile stock market and a remarkably stable GDP growth, together with an equally stable growth in “fair value” for the stock market. This difference is massive—two-thirds of the time annual GDP growth and annual change in the fair value of the market is within plus or minus a tiny 1% of its long-term trend as shown in Exhibit 1. The market’s actual price—brought to us by the workings of wild and wooly individuals—is within plus or minus 19% two-thirds of the time. Thus, the market moves 19 times more than is justified by the underlying engines!” (emphasis added.)

I’m sure you had an idea that institutions piling onto one side of the “risk-on, risk-off” boat and then quickly jumping to the other side was driving market volatility. The exact magnitude of the moves vs. the underlying fundamentals, however, may have surprised you, just as it did me when I saw the chart.

It amazes me that this data was calculated only to the end of 2005. As you know, price volatility since then has increased even further, reaching all-time highs in 2008.

Next week, we’ll talk about what individual traders and investors can do to respect, react and possibly even profit from the risk-on, risk-off paradigm. Until then…

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".

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