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February 23, 2005 � Issue #208 | |
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Feature Article 1 Being Right and Making Money Are Not Equivalent, by Van K. Tharp
Best Buy Dr. Tharp's Peak Performance Home Study Course. F-r-e-e Online Tutorial Optimizing Your Trading Results, By Dr. Chris Anderson
Tax Tip Reporting Your Earnings As A Trader, by Stephen S. Meredith
Recommended Reading Trade Your Way to Financial Fre-edom
Listening In 'Cannot Take Every Trade' - Advice From One Trader To The Other.
Being Right and Making Money Are Not Equivalent By Professional Trading Coach Van K. Tharp How important is it for you to be right? Let�s say I could guarantee that you would make money by the end of the year � lots of money � but you would probably lose money on 90% of your trades. Would you like that? Could you tolerate that? Would you accept that? Most people would probably answer "no" to all three questions. And if that is you, you probably are denying yourself the opportunity to make money simply because being right is more important than making money. Some of you might be saying, "How could you be wrong 90% of the time and still make money?" The solution goes back to the golden rule of trading, "Cut your losses short and let your profits run." Let�s say that 90% of your trades lose money and that your average loss is $100. On the year you make 100 trades so you end up losing 90 of them for a total loss of $9,000. However, let�s also say that your average winning trade is a big R-multiple. It�s an R-multiple of 100 or a $10,000 winner. You have ten of those in a year, so you end up making $100,000 on your winning trades. If you subtract your winnings from your losses, you�d end up with a profit of $91,000 at the end of the year. You make $91,000, yet 90% of your trades are losers. My guess is that 99% of the trading population could not trade a system that would produce those kind of results. The reason is because they don�t get to be right enough. They have too many losing streaks. They have losing streaks that are longer than five in a row. Most people cannot tolerate long losing streaks. When they occur, they totally abandon what they are doing. In such a system you could easily have 25 consecutive losses. At that point you become certain that your system is broken, and you try something else. Let�s look at the opposite end. Suppose you got to be right 90% of the time. Suppose your average win was $100 and that your average loss was $2,000. This means that you�d have a total of $9,000 in winnings and $20,000 in losses. You would lose $11,000. Would people trade that system? Yes, they would. They would probably trade it for a number of years until they went bankrupt. Why? Because they get to be right most of the time and that is very rewarding. You might be saying, but how could people possibly tolerate losses of $11,000 after 100 trades? It is easy, they turn the losing trade into a long term investment in their mind and say "it�s only a paper loss." For example, I�ve had workshop attendees who were probably way above average in terms of sophistication. However, I asked them to raise their hands if they had an investment in their portfolio that was only worth 50% or less of what they paid for it. Eleven people raised their hands�over a fourth of the class. And my guess is that among the overall population of investors, most people are sitting on a number of big losers, hoping they will come back. Why? Because they cannot stand to be wrong on an investment and they are waiting to be right on those losing trades. What is the cost of having losing investments in your portfolio? It�s major. First, you are using valuable capital up with nonproductive investments. Second, you are missing many good opportunities. Why Being �Right� Seems So Important There are two primary reasons why we focus on being right. First, we are conditioned to be right by the school system. Second, everyone in the trading industry gives people what they want � ways to be right � which tends to perpetuate the myth. Let�s take a closer look at these two reasons. First, we are conditioned by the school system to the importance of being right. In school you are taught that there are right answers and wrong answers. What is a right answer? If you learned how to survive in the system, you learned that a "right" answer is whatever the teacher wanted. Your performance is measured periodically through tests in which you are asked to pick the right answer. If you cannot get more than 70% right on the test, you are labeled a failure and ostracized. Your humiliation might even be in public in front on all your friends. And if your humiliation isn�t public, it certainly is semipublic. Your "poor" performance goes home in the form of a grade with a comment that "Johnny is a little slow or Johnny is bright, but he just doesn�t try." Usually, at this point, the most important people in your young life get involved - your parents. Even if you understand the system and work hard to know the right answers, you still might be taught that your performance is not good enough. It usually takes 94% right to get an excellent grade. But how many children go home and show their 94% test to Dad only to get the response, "Why didn�t you get 100%?" Thus, it is no wonder that traders want to be right all the time. And being right usually costs them dearly in terms of profits. Whether you�ve been through 20 years of schooling and have a graduate degree or less than 10 years of schooling, you still have the same conditioning about being right. The second reason people want to be right is that service providers for traders and investors feed the bias to be right. First, software vendors tend to provide systems that can be highly optimized. Once you�ve optimized your trading, you can lay a line over the prices and see exactly where you should have bought and sold. It seems obvious. However, the same optimized system does very poorly when applied to the real world. At investment conferences, the hottest speakers are those who provide information about high probability entry techniques. If you say "trade with the odds on your side" and show someone a technique that is right 75% of the time, you�ll get a large audience. Yet most techniques of this nature usually have big losers and may not even have a positive expectancy. Nevertheless, being right 75% of the time is all is takes to get people to trade them. The Solution: Expectancy What you must do now that you are trying to survive in the real world, is learn about expectancy. My book, Trade Your Way to Financial Fre-edom is one of the best sources I know that covers this topic. By definition expectancy is how much you can expect to make, on the average, over many trades. Expectancy is best stated in terms of how much you can make per dollar that you risk. In Trade Your Way to Financial Fre-edom I cover this important topic as well as detailed instructions on how to calculate expectancy. In my workshop and home study program on How to Develop A Winning Trading System we really focus on this topic and show you how to incorporate expectancy into a successful, profit generating trading system. 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.
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Best
Buy:
Peak Performance Course
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This week's F-r-e-e On-Line Tutorial Optimizing Your Trading Results
Education brought to you in a brand new way. Follow the link below and join us in this fun new way of learning. C-l-i-c-k Below
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Tax Tip of the Week Reporting Your Earnings As A Trader by Stephen S. Meredith, CPA, PLL Where do you report your stock sales and other expenses if you are a trader and have made the election to be treated as a trader under section 475(f)? Let�s first look at the normal reporting. If you are an investor in the stock market you report your stock sales as capital gains or losses on Schedule D of your tax return. Any investment expense that you incur, such as management fees or investment advisor fees, are reported on schedule A. Unfortunately, these expenses are subject to the 2% of adjusted gross income limitation, so they are not fully deductible. Additionally, if you have a net loss, the loss is limited to a maximum deduction of $3,000 per year. Any amount of loss over that has to be carried over to future years. Traders who make the election under section 475(f) report their transactions differently. The stock trades are reported on form 4797 (sales of business property) on line 10. You will probably have to attach a continuation sheet because there are only about four lines to report trades and that won�t be enough for the average trader. The loss is not limited to $3,000 per year and can be claimed in full regardless of the amount. A trader reports his or her investment expenses on Schedule C, which is not subject to the 2% of adjusted gross income limitation. The election under 475(f) has to be made for 2005 by April 15, 2005. If you are an individual, you make the election by attaching a statement to the 2004 return setting out which activities are going to be trading activities. It is possible to have two brokerage accounts and use one for long term and one for active trading investments. By specifying the account you can identify which ones are treated as trader status for tax purposes. For a new organization, such as a Limited Partnership or Limited Liability Company, the election has to be made by writing a statement and putting it in your records and attaching it to the first return filed by the new organization. Should you do your trading in a corporation? For short term trades it doesn�t matter very much except for the Personal Holding Company Tax. This is a tax penalty assessed against a corporation that has at least 30% of their income from passive or investment income such as capital gains, rents, royalties, interest or dividends. As a Trader this may be irrelevant since the trades are generally short term and are considered active income. But if you have long term gains and want capital gain treatment, you have two problems. First, corporations do not get the benefit of a capital gains tax rate. All capital gains are taxed at ordinary corporate tax rates. Second, personal holding companies get taxed at the maximum personal tax rate automatically. Pay particular attention to the trader rules if you are doing regular trading and want to get the special treatment as a trader. Stephen S. Meredith is a CPA in Richmond Virginia. He specializes in preparing income tax returns for all types of businesses, individuals, estates, and trusts. He also consults with new business owners on how to properly structure their business to get the maximum benefit from current tax laws. Steve deals with many stock market and real estate investors. He has clients nationwide and lectures regularly on tax topics.
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Recommended
Reading:
Trade Your Way To Financial Fre-edom by Van K. Tharp Learn what the best traders in the world do to produce top notch systems. The Holy Grail for you is in knowing yourself and your biases and how to overcome them. In this book, you'll learn specific techniques for overcoming your biases, entry techniques used by the masters, how to develop a high expectancy system through understanding exits, and how to achieve your objectives through proper position sizing. There are many critical topics that most books ignore such as expectancy, R-multiples, position sizing, the importance of objectives, and many more. 344 pages. $29.95
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Excerpts from Dr. Tharp's MasterMind Trading Discussion Forum
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Van Tharp's Most Recent Market Update including the 1-2-3 Model and the Five Star Model. Look for a new update next week. |
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Quote of the Week:
"We ascribe beauty to that which is simple; which has no superfluous parts; which exactly answers its end; which stands related to all things; which is the mean of many extremes." |
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