In this Issue:

Feature Article	Using Simulation to Determine Your Worst Case Drawdown, By Van K. Tharp, Ph.D.
Listening In	Commitment

  

Quote of the Week: "The significant problems we face cannot be solved at the same level of thinking we were at when we created them"  ~ Albert Einstein~ Feature Article: Using Simulation to Determine Your Worst Case Drawdown By Van K. Tharp, Ph.D. One way to do safe position sizing is to determine how big of a loss you would be willing to tolerate in your original equity. Let’s say, you are trading $40,000. You would be willing to risk $8,000 of that $40,000 in our trading strategy or 20%. How much could you risk? I usually suggest that 1% would be fairly safe, but let’s look at it one additional way. IITM’s simulator (not yet available) can simulate an R-multiple distribution 10,000 times and keep track of all sorts of information. We plugged in a sample distribution that has two 10R winners, seven 1R losers, and one 5R loser as our system and we’re going to assume that we make 30 trades a month. Thus, we know the expectancy of the system is 0.8, but can we determine what percentage of 30 trade games will have a positive expectancy? Certainly, with 80% losers, we know that some 30 trade blocks will lose money. We can also determine the worst case drawdown in terms of R. In other words, how many times your basic risk are you likely to lose (as a worst case) during the 30 trades. And what’s the worst case drawdown over 10,000 simulations? The first statistic that stands out is that we have about a 82.5% chance of making money in this game in 30 trades. That means if we were doing 30 trades per day, we’d make money on four out of five days. Superb system. If we were doing 30 trades per month, we’d make money on four out of five months. Great system. And, if we were doing 30 trades every year, we’d make money on four out of five years. Good system. Another interesting statistic are the losing streaks we might experience. These are shown in table one. The left column shows the size of the losing streak and the right column shows the probability of getting a streak that big or bigger. Notice that in 30 trades, you have 100% chance of getting at least six straight losers and a 43% chance of getting at least 10 straight losers. Most people would think that a system was broken when they got 20 straight losers, but it apparently would happen about 2.6% of the time. Actually, I’ve played this game about 150 times before various groups. I’ve seen one losing streak of 24 straight losses and another losing streak of 30 straight losses. The game with 24 straight losses actually made money at the end of 30 trades, but the 30 straight losses was a disaster. But now let’s look at the most critical information for safety – how big might our losses against us be in terms of R? These are shown in the table two The left column shows the size of the drawdown (cumulative loss) in terms of R and the right column shows the size of the probability of getting a loss that big or bigger. Our simulations showed that the average drawdown was 16.6R and that the maximum in 10,000 simulations was 60R. So how do we use this information to determine position sizing? We decided at the beginning of the section that we were willing to lose up to 20% of our starting equity. If we divided 20% by the average maximum R-multiple drawdown of 16.6R, then we’d be able to risk 1.2%. However, this would give us about a 50% chance of a 20% drawdown in our equity somewhere in the 30 trades. If we use the maximum drawdown of 60R, then we’d get 0.3% risk. Risking 0.3% would tell us that we had about one chance in 10,000 of losing as much as 20% of our starting equity. And if we were willing to tolerate a 5.8% chance of losing 20%, then we should probably risk 0.67% — almost at our original 1% estimate. Once again we must emphasize that simulator results are only accurate when you really know your R-multiple distribution. We know the R-multiple distribution of the marble game, but one can never do better than a rough estimate of the R-multiple distribution of your system.    1 This article was taken from Van’s new book, Safe Strategies for Financial Freedom to be published by McGraw Hill in the spring of 2004.   In the unique arena of professional trading coaches and consultants, Van K. Tharp stands out as an international leader in the industry. Helping others become the best trader or investor that they can be has been Dr. Van Tharp’s mission since 1982. He offers very unique learning strategies, and his techniques for producing great traders are some of the most effective in the field. Over the years Dr. Tharp has helped people overcome problems in areas of system development and trading psychology, and success related issues such as self-sabotage. He is the founder and president of the International Institute of Trading Mastery, Inc., dedicated to offering high quality products and services for traders and investors.   Van Tharp's How to Develop A Winning Trading System  That Fits You Home Study Course One of the biggest secrets of successful trading is trading a system that fits you.  In fact, Jack Schwager, after interviewing enough “market wizards” to write two books, concluded that the most important characteristic of all good traders was that they had found a system or methodology that was right for them. When someone else develops a system for you, you don't know what biases they might have. Developing your own system allows for compatibility with your own beliefs, objectives, personality and edges.  More Info About How You Can Develop Your Own Trading System...   Listening in.... Excerpts from Dr. Tharp's Discussion Forum.  Van-Question  Author: Kevin Date: 08-21-03 07:31 Van, ... regarding the reasons for trading other than to make money. Could you present some of these reasons, and comment on them, in general terms? Reply To This Message  Author: Van Tharp  Date: 08-21-03 15:36 I've always said that to get commitment you have to find your purpose in life and clues to that are usually what you love to do. The best traders that I know of want to be the best. For example, one trader in [the book] Market Wizards has such a routine that every minute of his day is totally planned. I did a workshop for his company and expected to have dinner with him....but no that wasn't part of his plans ...too much wasted time. Everything he does is focused on making at least 20% on the billion plus dollars he trades. Ed Seykota once said, "I'm like the lion and I weed out the sick and the lame so that the herd is strong." Others say, I make a lot of profits with the idea of giving back to the world -- such as 10% to charity. Or how about all the projects that George Soros does...or Paul Tudor Jones' Rainbow Foundation. Hopefully, you get the idea. Reply To This Message  Re: Van-Question  Author: Chris, Date: 08-25-03 15:49 Some great traders trade simply because they enjoy it. They see it as playing a fantastic game, or brain tease, similar in a way to my grandfather that enjoys "beating" the Sunday paper crossword puzzle. Their total equity is simply a way for them to keep score. Reply To This Message  Author: Kevin ,Date: 08-26-03 07:31 Chris, I hear you on this. It seems to come down to anything that you commit to in life- if you are doing it just for the paycheck, and not the love of it, then you probably will never be the best that you can be. There needs to be a purpose behind your motivation that is more than just financial. Kevin

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