Tharp's Thoughts Weekly Newsletter (View On-Line)
My Journey through Losing Marbles and Position Sizing™ Strategies: Part 2 by D. Witkin
The VIX: Trading Volatility by D.R. Barton, Jr.
Is Hyperinflation a Possibility?
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My Journey through Losing Marbles and Position Sizing™ Strategies: Part 2
This week's article is Part 2 of a three-part series from an excerpt of a new book that Dr. Tharp is working on due out in late 2012. This book will be a compilation of Dr. Tharp's insights as well as personal stories of transformation from traders. You can read Part 1 of the series here.
I love to learn, and I was excited any time an author could add some knowledge to my repertoire. So, I became excited as I read Trade Your Way and came to view the book—though Dr. Tharp might disagree—as not just about psychology, which seemed like such an intangible way to view trading. [Note from Van: I consider everything to be 100% psychology these days, but in the scheme of things, Trade Your Way was about system development.] The book included very tangible suggestions, and the author clearly understood how I thought about trading.
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I hadn’t realized it before, but I was really looking for a perfect system, or the Holy Grail as Dr. Tharp refers to it. In short, Holy Grail systems focus on picking the right stocks and when to enter the market and should pretty much work whether the market is bullish, bearish, or neutral. He was exactly right. I didn’t want to think about having different systems to enter the market—one when I was in a bullish market, 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 of market? 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.
Unfortunately, Dr. Tharp said finding a system that worked on all types of markets was very rare. “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, and at this point I had no concept of the amount of work required to implement all his ideas. Double-ugh.
He also said making a lot of money in the markets would not be fast or easy. “I don’t like this guy,” I thought. Reading that type of stuff was frustrating. As much as it made sense, I really didn’t want anyone telling me how hard it 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!
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 this Dr. Tharp guy 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 non-trading career. 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.)
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. You decided not to paper-trade the recommendations for 6 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 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. Go ahead and try the exercise above with any external source you counted on for trading advice and see as at fault for some losses, and try to figure out how you might have caused a disaster you blamed someone else for. Your broker told you to buy that stock and you trusted him? 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 see the possibility of him stealing your money as likely. You also chose not to split your money into three equal parts and give each part to a different money manager. Go ahead—try the “it wasn’t my fault” game the next time you lose money. If you can’t trace the results back to you, ask someone else to help you and tell them to be relentless.
How can you fix something if you don’t think you were responsible for it happening? Is it possible you didn’t do all the checking you should have on that newsletter because you didn’t know who to talk to? Or maybe you didn’t independently validate the results because you didn’t know how and didn’t hire someone to do it for you because it would have cost you $500? Maybe you didn’t want to wait to make money and thought about all the money you wouldn’t be making if you paper-traded the system for six months before putting real money on it? Or you relied on a recommendation to trade based on a newsletter from someone who turned out not to be credible? Test yourself—if you aren’t able to come up with five to ten things you could have done differently, you’re not trying hard enough. More importantly, you’re more likely to continue to struggle at trading successfully.
The book said most people think of a trading system as the answer to the question, “When do I enter the trade?” Unfortunately, when to enter is the least important part of a trading system. I’ve heard both Dr. Tharp and Linda Raschke, another trader mentioned in a Market Wizards book, 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 then use good exits to accept losses and take profits, and seem to confirm the relative importance traders should ascribe to entries.
Even with all of the things that resonated with me, there were plenty of things that didn’t, at least not immediately. For example, Dr. Tharp argued a good trading system would have 10 parts, the most important of which is objectives. Objectives? 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 or she could make in any year? Unfortunately for my ego, the book makes a good case for objectives and other trading system decisions being more important than entries.
To be concluded next week...
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The VIX: Trading Volatility
Since we’ve been talking about the CBOE Volatility Index for several weeks, some readers have been wondering how to make a trade based on an expectation for volatility movement.
Immediately, one phrase comes to mind: buyer beware!
There are tradeable instruments for volatility out there, but there is certainly much confusion over what to use and when. So here are a few guidelines:
- As with any purchase of a stock or Exchange Traded Fund (ETF), make sure the instrument trades in sufficient volume. For most swing trades, a minimum 21-day average volume of 100,000 shares per day should be your line in the sand. 250,000 or more shares traded per day would be even better. In general, the higher number of shares traded, the smaller the spread between the bid and ask prices, which leads to lower transaction costs. In addition, with higher volume instruments, there is less slippage when filling orders. (Slippage is the difference between the price at which we wanted to have our order executed and the price where it actually did get executed.) Here is a list of active ETFs and their average volumes from the ETF Database site. As you can see, there are only a handful that have high enough volume to use.
- Once you’ve found an instrument with sufficient volume, check to see how the actual tradeable instrument moves relative to the underlying index. In the case of volatility ETFs, it is tough to find one that matches the VIX index. Let’s look at two ETFs that are typical of all of the ones in the list above. First VXX, which tracks a short-term volatility index. Notice that the August 2011 and October 2011 peaks in the VIX index were roughly the same magnitude. Not so with the VXX.
We might expect that a longer-term volatility ETF would rectify this problem. However, looking at VXZ, which tracks a mid-term VIX index, we see that the price movement is the same shape, with only a slight difference in magnitude.
Yes, there are tradeable instruments that you can use to play changes in volatility, but take care to only use the most liquid ones. Also, be aware that price movement can vary versus the standard VIX index that most people are used to tracking.
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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Is Hyperinflation a Possibility?
Q: The likes of Jim Rogers say that high inflation in USA is very likely, others even suggest possible hyperinflation, due to the huge increase in the monetary base and the high level of debt. Some studies even suggest that the USA is already bankrupt in theory/principle as mentioned in your monthly market update.
Do you think hyperinflation is a possibility? If so, how do you think it will influence the trading and the market liquidity/volumes?
What if hyperinflation develops and a lot of people want to liquidate/close their accounts or pull the money out of USA and liquid US dollar assets, maybe even out of listed stocks? (The latter should quickly rebalance/rebound if they have valuable hard assets.) Although hyper-inflation would probably start gradually, you can already see a higher than normal inflation.
A: Van believes the only way for the US to pay its debt is through inflation (i.e., paying its debt back with cheaper dollars). He believes that will happen at some point and that may be a hyperinflationary environment. Interestingly, John Mauldin wrote recently that he disagrees with any hyperinflationary scenario completely for the US—the regional federal reserve banks simply won’t support the actions required for that in spite of what the people in Washington, DC may want. The structure of the governing boards at the regional level include too many non-federal reserve employees (read regional business executives) to allow that to happen.
Regardless and in the meantime, Van also believes we could experience deflation prior to that inflationary stage. This is why he tracks both sets of forces in his monthly market update.
An inflationary environment might send the market higher—or at least significant portions of it. Where do people want to put their money? In things that are going up. I don’t believe most Americans on a large scale will pull their money out of the US dollar and US dollar denominated holdings; that’s just not what they have done in past inflationary environments. That behavior could change on a large scale, however, should hyperinflation kick in and drive up the price of precious metals. But like most herd action, that will be at the mid-point or later in the cycle. Those are all my beliefs there, which have been strongly influenced by Van.
Whether we will see deflation or inflation, or both, as an outcome of the high level of debt around the world, the current and upcoming periods promise a lot of dynamic and broad structural changes (another belief).
Van shares his beliefs directly in the first newsletter of every month in his market update.
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