The Van Tharp Institute

February 16, 2005 — Issue #207

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In this Issue:

Feature Article 1

Benefits Of Systems With A High Winning Percentage, by Chuck LeBeau

F-r-e-e Online Tutorial

Low Risk Entries With Pre-construction Investing? By Dr. Chris Anderson

Trading Tip

Useful Valuations & Conclusions, Housing Bubble or Housing Bull Part VII, by D.R. Barton, Jr.

Recommended Reading

When You Are Troubled

Listening In

What Attendees Said About The Recent ETF (Exchange Traded Funds) Workshop

View this newsletter on-line, or read back issues

 

Feature Article 

BENEFITS OF SYSTEMS WITH A HIGH WINNING PERCENTAGE

by Chuck LeBeau

You will notice that a lot of the systems I offer tend to have a high percentage of winning trades. This is no accident. Although it is not essential for a system to have a high winning percentage in order to make money, there are many advantages for those systems where the frequency of profitable trades exceeds the losers. Here are a few of our observations on this important subject.

1. Systems with a high winning percentage are much more rewarding psychologically. No one enjoys losing. Everyone enjoys winning. Systems that encounter frequent losers and rely on occasional big winners to make money are not enjoyable to trade. Unfortunately the moral of the trader is not a performance measurement that typically appears on a historical performance summary but perhaps it should be. Strings of losses are demoralizing regardless of your attitude or experience. Strings of profits are always fun and build confidence and self-esteem as well as building your bankroll.

We often hear about excellent systems that are abandoned by their operators in spite of a long-term record of profitability. These tend to be trend following type systems with a low winning percentage. It would take the faith and patience of Gandhi to trade some of these systems in spite of their appealing long-term track records. It should not be surprising that most traders fail.

2. Systems with a high winning percentage are likely to have lower drawdowns. Assuming that the worst case loss on a per trade basis is strictly limited, as it should be, abnormal drawdowns are most likely to be caused by a long string of trades wherein there are very few winners. Large drawdowns are rarely the result of a long string of consecutive losses. Drawdowns are most likely to be caused by the absence of regular profits. Perhaps I am saying the same thing two different ways but I think there is a difference. For example six losses in a row followed by a winner and another six losses in a row is likely to produce a larger drawdown than ten losses in a row. Obviously the higher the winning percentage the less likelihood of stringing together a long series of trades with only occasional winners. Of all the historical performance factors that we can evaluate, the winning percentage is most likely to be predictive of the possibility of large drawdowns. If we can design a system that has a low average loss and a high winning percentage we are looking at a system that should be very drawdown resistant.

3. Systems with a high winning percentage reinforce discipline. How often have we heard stories of traders who are following a system and after a series of losses decide to skip a trade only to have that skipped trade turn out to be a big winner? This is not the trader's version of an urban legend horror story. It actually happens very frequently. If we are trading a system with a low percentage of winners, it becomes increasingly tempting to start skipping trades. Lets assume we are trading a system that only has 30% winning trades. Since the odds appear to favor our skipping trades we will tend to be rewarded for our lapses in discipline. For a while we will benefit from skipping trades until we inevitably skip the big winner. That is usually when the system is abandoned because, having skipped the winner, we aren't about to jump back in to experience the next string of losses.

On the other hand, if our system has a high percentage of winning trades, we shouldn't be tempted to start second-guessing the system. We know up front that if we skip a trade the odds are that we will be skipping a winner. The favorable odds of the system will help us to maintain the necessary discipline to operate the system exactly as it was designed.

4. Systems with a high winning percentage require less diversification. The typical trend following system is extremely dependent on finding markets where a very large trend will occur. These large trends are relatively rare and to make certain that we are in the right market at the right time we must diversify our trading among many markets because we can't afford to miss one of those big trends. By diversifying as much as possible we are more likely to catch the big trend that makes back all of our losses and rewards us with a profit. However, in spite of what some portfolio strategists would have us believe diversifying a low percentage system actually increases the likelihood of a major drawdown rather than decreasing it.

However if we are trading a system with a high winning percentage we have much less need for diversification. And if by careful design our high percentage system is also capable of catching big trends, we have the best possible scenario. After all, there is no logical reason that a system with a high winning percentage can't also have big winning trades now and then. It all depends on the effectiveness of our exit strategy. Of course, diversification will still benefit our high percentage strategy but it will be an optional enhancement rather than a necessity.

5. Systems with a high winning percentage require less capital to operate. If we need less capital to survive drawdowns and less capital for diversification, it follows that we need less capital to start trading the system. Also, with a high winning percentage we can be more optimistic about starting with less capital and using our profits to build up our capital prior to any major drawdown.

6. Systems with a high winning percentage are easier to troubleshoot. Imagine a low percentage system where long strings of losses are the norm. How many losses will it take to get your undivided attention and tell you that something is seriously wrong? Too many, I suspect.

Now imagine a system with a very high percentage of winners. Almost any series of losses is going to be out of the ordinary and will quickly attract our attention. Hopefully we will be able to perform a prompt review of the system and correct any faults while we still have some capital left. Unfortunately if we are trading a low percentage system we could run out of capital before we realize that our low percentage system has deteriorated even further.

As you can see I am a strong advocate of systems with high winning percentages. In my opinion there is no excuse for designing a system with a low percentage of winners. I contend that it's not really difficult to design a system with a solid winning percentage if you focus on that statistic and make it a requirement. Too often system designers tend to focus entirely on total profitability. Many times this emphasis tends to result in letting profits run too long (curve fitted profit exits) and perhaps using stops that are too close. Both of these preferences will hurt the winning percentage and degrade the system. On the other hand, if we set out to have a high winning percentage we can obtain it without sacrificing much, if anything, in the way of profits and we will create a system that is extremely "user friendly" and reliable. 

(Comment from Van Tharp: It's important to note that some people design high probability systems that have a negative expectancy (i.e., when they lose they lose big). Our How to Develop a Winning System course will give you all the pros of cons of this and many other system strategies)

About the Author: Chuck LeBeau  is the co-author of Computer Analysis of the Futures Market, and the former co-editor of Technical Traders Bulletin. Chuck is a featured speaker at IITM's  upcoming How To Develop A Winning Trading System Workshop, November 12-14, 2004.. Chuck has 27 years experience in the markets and is widely known for his specialized knowledge of technical analysis. He also develops trading systems and currently runs a website devoted to trading topics; www.traderclub.com. This article is under  Bulletins  from the "forum" section of Chuck's informative site.

Editors Note: Throughout the issues you will see certain words with odd spellings, such as Fre-deom and mort-gage. This is because spam filters are likely to block message that contain certain words and this is one solution.

 

Video Article

This week's F-r-e-e On-Line Tutorial

Low Risk Entries With Preconstruction Investing?

Education brought to you in a brand new way.  
By Chris Anderson, PhD

Follow the link below and join us in this fun new way of learning.

 
C-l-i-c-k Below

On-Line Tutorial

 

Trading Tips

Trading Tip

by  D. R. Barton, Jr.

Housing Bubble or Housing Bull Part VII:

Useful Valuations & Conclusions

In my last article, we took some time to reflect on the data provided during our series.  I drew the conclusion that most of the data points to an extremely over-priced housing marking.  BUT we also talked about the wildcard that continues to drive the housing market – demand.  How much more unmet demand is out there?  That’s a question that is incredibly difficult to answer, but it is not slowing down yet.

A key issue that I mentioned last week which could help you make housing market investment decisions is the issue of fundamental values for housing.  How do we determine when housing is fundamentally over-priced or under-priced?  Several people have come up with a formula of median home prices compared to median annual rents for a given area.  (In my research, I couldn’t determine who came up with this idea first.)  This gives us some sort of fundamental valuation for housing, much like a Price-to-Earnings (P/E) ratio for stocks.

Edwarn Learner, a UCLA economist, did a study of the largest nine metropolitan areas in the U.S. using this fundamental valuation of homes as described in the previous paragraph. The number had gone up by an average of 40 percent over the five year period leading up to 2002.  That is a strong appreciation in fundamental value, and obviously is much ahead of inflation.  In a quick check of two of the areas, the number is still going up in the last two years.

When stock P/E ratios get overvalued, we look for a correction in the market.  The same could be said of housing prices, with two caveats.  The first is that the housing market tends to move much more slowly than the equities market.  The second is that we still have the overwhelming issue of continuing strong demand, that shows no significant signs of slowing.

So what can we conclude?  At minimum, residential housing is certainly not the “no brainer” investment that it has been in decades past.  Care should be taken in evaluating real estate markets before jumping in.  But one additional item needs attention.  Real estate is a very regional market.  Some areas are much closer to “bubble status” than others.  Take a close look at the historical fundament valuation for houses in any area you’re considering.  This could be the first hint of whether prices in that market have reached unsustainable levels.

The bottom line:  I’m not ready to call it a housing bubble just yet.  But prudent investors will do much more homework than at any time in the recent past if they want to make money in residential real estate.  The first chink in the “housing demand” armor that is currently protecting the real estate market could start a downward spiral that would like many other bubbles that have been experienced in the financial markets.  In most areas, caution is the watchword.

D. R. Barton, Jr. is a lead instructor for Van Tharp Institute courses. He is the Chief Operating Officer and Risk Manager for the Directional Research and Trading hedge fund group. D. R. has been actively involved in trading, researching and teaching in the markets since 1986.  D. R. has created extensive and innovative new training products and taught extensively in many investment areas including intra-day trading, swing trading, and cutting edge risk management techniques. 

His writing credits include co-authoring Safe Strategies for Fin-ancial Fre-doom and co-creator and contributing author on Fin-ancial Fre-doom Through  Electronic Day Trading. He also writes a stock screening newsletter called Ten Minute Trader, has feature articles in Market Mastery, writes for Traders-U and is a regular contributor to Tharp's Thoughts.

 

Recommended Reading:

When You’re Troubled – The Healing Heart  - James Sloman

Jim Sloman’s book, "When You’re Troubled, The Healing Heart", is an inspirational book offering assistance no matter what challenges you may be facing in your life. It’s the perfect addition to your library or an exceptional gift for friends. The book covers clear and practical universal principles concerning:

- Relationships - Goal Setting

- Meditations - Childhood Issues

- Visualization - Nutrition

- Paradigms - Vitality

Whatever your age, your background, or situation, you can greatly enhance and even transform your life by spending some time with this unique book.  504 pages, $35.00

Order Book

 

Listening in....

 

Feedback from Van Tharp's Recent Exchange Traded Funds Workshop:

"One Word: Excellent....I learned how to fit ETF's into my current strategy. The "world model' created by Ken helped me identify macro trends much easier." Ferdinand Ledesma

"It's worth the time and money. [Ken Long is] very accommodating and responsive. He deserves more than a 10." Vito Pinto

"Superb! Great teacher, very enthusiastic and knowledgeable." Al Lizarraras

"Very helpful information that gave me a good foundation for putting ETFs into perspective compared to stocks and mutual funds." Mark Ledbetter

"Excellent stuff! Ken is a great teacher, human being and last but not least, trader." Leo Willert

"This was a great introduction to ETF's. I Especially liked that it showed me techniques for trading ETFs using short-term strategies. Al Mayo

"It's been exhilarating! I found Ken to be extremely clear and structured in his explanation and presentation of his systems, beliefs and techniques. Awesome information for traders of any level of expertise." Jordi Llobet Serra

"Very impressed. Ken over delivered on the course objectives and with a lot of his own real-world experiences, all with a good delivery and sense of humor. I leave feeling I can grow my account better than a market benchmark using a disciplined approach without a lot of weekly time and make a little extra using multiple strategies on ETFs." David Holland

"Outstanding. Most beneficial course I've attended." Michael Bonenberger

"Extremely comprehensive 'top down' approach to trading ETFs. Superbly presented by Ken Long in a very understandable format. I give this course a 10 out of 10. Good job! Ken is clearly a man of great integrity and because of this, he had my trust in the material he was presenting immediately." Tim Ridge

"Very thorough, detailed, with dedicated speaker who went out of his way. Great course Ken!" Mike Doseck

For those of you who called to say that you'd like to see this course offered again this year, stay in touch. This first course was excellent and we are looking at dates now to fit in a second course this year.

 

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