The Van Tharp Institute

February 23, 2005 ó Issue #208

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In this Issue:

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.

View this newsletter on-line, or read back issues

 

Feature Article 

Being Right and Making Money Are Not Equivalent

By 

Professional Trading Coach

Van K. Tharp

How important is it for you to be right? Letís say I could guarantee that you would make money by the end of the year ó lots of money ó 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." Letís 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, letís also say that your average winning trade is a big R-multiple. Itís 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, youíd 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 donít 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.

Letís 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 youíd 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 "itís only a paper loss." For example, Iíve 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 handsóover 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? Itís major. First, you are using valuable capital up with nonproductive investments. Second, you are missing many good opportunities.

Why Being ĎRightí 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 Ė ways to be right Ė which tends to perpetuate the myth. Letís 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 isnít 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 doesnít 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 didnít 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 youíve 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 youíve 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, youíll 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.

 

Best Buy:

 

 Peak Performance Course

 

Dr. Van Tharp is a consistent, astute and systematic researcher of human behavior. The opportunity to learn from someone of his caliber does not come along every day. He has collected psychological profiles from over 5,000 investors and traders and has personally interviewed hundreds of top people in the field to determine what makes them excel and how they make immense profits. 

He then carefully crafted the information from his studies into a model that people like you can use to improve your skills and increase profits. Furthermore, Dr. Tharp only studied people whose professional and personal lives were balanced. As a result, when you apply his model, it typically helps you lead a much happier and more satisfying life in all respectsónot only in your trading.  

"I discovered your course and enrolled... I began trading again and I could not believe the difference in how I felt when trading. The anxiety level was gone, sleepless nights disappeared." óTerrance R. Caffey

"I considered myself to be a top successful trader before taking this course and even more successful after completing "Peak Performance." I highly recommend it as a requirement in the basic training category to anyone interested in trading. That goes for beginners, average traders, as well as successful traders." óLarry Satell

 

Video Article

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

Optimizing Your Trading Results

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

 

Tax Tip

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)?

Letís 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 wonít 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 doesnít 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. 

 

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

Order Book

 

Listening in....

 

Excerpts from Dr. Tharp's MasterMind Trading Discussion Forum

Cannot Take Every Trade 
Author: T.L.
Date: 02-22-05 09:44

Hi!

How should you handle the fact that you want to act on every entry signal your system generates, but your money is limited? Based on Van Tharp's great book "Trade Your Way to Financial Fre-edom", I have set up a trading with system with a trend-following indicator, using stoploss and exit, and risk-based position sizing. Since I monitor quite a few stocks, I get several entry signals a week. My indicator has an accuracy of about 40%, so I need to act on every signal in a stock to be sure to catch the winner move.

The problem is that the portfolio risk sometimes does not allow me to take the trade. And more often, there is not enough money to take on the trade, even if the overall risk is not to high.

What is the best way to deal with this: allow lower risk per position, reduce the number of monitored stocks or change the parameters of the indicator to reduce its signal frequency?

Best regards,

Thomas

Reply To This Message 


Re:
Cannot Take Every Trade 
Author: PMK
Date: 02-22-05 10:19

Thomas,

The simplest way to approach this, assuming you have a position sizing model based on percentage of available equity, is to reduce this percentage to a point that allows you to take every trade. This should be based on the historical maximum number of concurrent positions you have had with the system. If this means you end up trading odd-lots (assuming you are not trading HOLDRS) then so what? Yes, your commission as a percentage of risk will increase, but that should not be enough to turn the system from positive to negative expectancy.

Also, if you do not already have one, you could introduce a filter to reduce the number of stocks you consider tradable, and therefore the number of signals you get. Only trading higher volume, higher market capitalization and higher priced stocks usually leads to less slippage, tighter spreads, and therefore reduced trading implementation costs even though opportunity will decrease.

I would not recommend changing your other system parameters simply to produce less signals, unless you can do it in a way that increases expectancy significantly i.e filter out more losing trades than winning ones. Systems should be tuned to produce the maximum opportunity possible without decreasing overall expectancy.

Lastly, if none of the above are possible, then you could consider either adding capital to your account, trading on margin to increase available capital, or trading options instead of the stocks themselves (which usually requires less capital outlay). Note that these last suggestions should only be taken if you have a proven track record of positive results with real-money testing this system.

PMK 


Read the full, unedited thread on the forum,   link here. (Hint for finding it, look at the heading and the date) Van K. Tharp and traders, investors and wealth builders around the world connect on this site, share ideas and learn from each other. Search specific topics 

 

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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." 
-- Ralph Waldo Emerson

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  www.mastermindforum.com

Ask questions, share ideas, information and feedback with Dr. Tharp and other like-minded traders and investors.