Tharp's Thoughts Weekly Newsletter (View On-Line)

• Article Skill and Luck in Trading, Part Two, by D. R. Barton Jr.
• Trading Education Check out the February Workshops
• Trading Tip The Proper Order for Trading Preparation
• Ken's Trade of the Week Video A 10R Trade Was the Reward

Don't Buy The Book!

You may have noticed that Van has a new book coming out soon. We are so excited and think it's his best book yet. But here's some contrarian advice:

Don't buy this book! (. . . or not just yet.)

You may think we've gone mad, but we have good reasons. If you wait until the publisher’s release date to buy the book, you can earn a slew of promotional offers and free products from the Van Tharp Institute.  The publish date will most likely be February 18 so hold off on the temptation to pre-order it and you will be richly rewarded.  We'll give you more details as the time to buy draws nearer.

Feature

Skill and Luck in Trading, Part Two

by D.R. Barton, Jr.

View On-line

When Alabama faced Notre Dame for college football’s national championship on January 7th, there was more hype before the game than perhaps any championship game in decades. The Wall Street Journal even gushed that it was like eating the best dessert ever. The resurgent Fightin’ Irish were set to give the defending champion Crimson Tide a real game—at least according to a hopeful press corp.

Football insiders and the betting public know better. Alabama was favored by nine or more points – a huge margin of difference for a game between football’s elite. Sure enough, within a few minutes of the game, it was clear that Alabama was not only stronger on the line of scrimmage, but also faster at the skill positions. The rout was on. When all was said and done, even the wide difference in the 42-14 score didn’t fully describe how one-sided the game was.

When skill levels vary this widely, luck rarely plays a major role in who comes out on top in a game. When two teams with extremely close levels in skill play, however, luck can be an important factor in the outcome of an individual game. Even if individually matched teams win five games in a ten game series, predicting who will win any single game remains difficult.

And that brings us to the activity of trading. Luck (or chance) plays a large role in every single trade largely because both sides of every trade tend to be highly skilled players.

Luck vs. Skill in Trading

Last week we started a discussion of concepts from an interesting new book, The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing by Michael J. Mauboussin. The author does not argue that one cannot outperform in markets (he doesn’t blindly subscribe to the efficient market hypothesis). But he does some useful analysis describing why luck (or chance) plays such a large role in investing and trading.

In an early chapter, Maubossin describes the paradox of skill, a phrase he didn’t coin, but one he does amplify. As skill levels increase among participants in an endeavor, the differences in performance from the top to middle or even top to bottom starts to shrink. As the difference in skill levels shrink among participants, then the results for any single event depend more and more on luck or chance.

This line of thinking leads to two interesting questions – How does this play out in trading? And, what impact does it have on individual investors and traders?

Let’s first deal with skill levels in the field of trading. For more than a generation now, pay levels for Wall Street have been a source of great debate. Whether you agree or not with the enormous sums that the industry’s elite receive, there is little question that the opportunity to earn such large piles of money attracts the best and the brightest. For almost every trade or investment made, there are certainly intelligent and determined people on both sides of the trade.

With many players and almost an infinite number of influences, the investment markets are certainly complex. And because market prices are set by human buyers and sellers, the system will remain adaptive; the only constant will be change…

And when we combine highly skilled players who compete in what can best be classified as a complex adaptive system, then chance will play a large role in each outcome.

That’s not to say that outperformance is impossible. Maubossin points out that there is a big difference between an activity that requires all luck and one that may only require a significant component of luck. He cites two journal articles from 2000 and 2010 that state that most active fund managers outperform the market—before their performance fees. It is these fees or payments to the managers and firms that drive the net fund performance below benchmarks like the S&P 500 returns.

What Does This Mean for Individuals?

Skilled individuals actually have an advantage versus professional managers –individuals don’t have to overcome large fees (as much as 20% and higher for hedge fund investors) and can pocket any outperformance.

This circles us back to what’s important for individual investors. I received an interesting email that asked if trading has a large component of luck for any individual trade, how we can maintain personal responsibility for that trade as Van advocates?

The answer comes in two parts. First, we have to maintain absolute responsibility for the process we use to execute the trade. Did we follow our trading plan for the entry, position size and exit? And secondly, we have to have the mental discipline to know that, as market wizard William Eckhardt said, “no one trade is important.” It is in the aggregate that we will realize our trading edges.

Next week we’ll dig more into the issue of inherent uncertainty in trading and investing. Until then, I welcome your comments and feedback. Send them to drbarton “at” vantharp.com Great Trading, D. R.

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".

Disclaimer

Trading Education

These two February Workshops are essential for all traders, but heads up, the Feb date is the only time they will be held in the US in 2013.

Most traders take one of two routes when it comes to trading systems. However, both of those approaches tend to produce inconsistent results at best, and at worst, cost you a lot of time and money. In the How to Develop A Winning Trading System Workshop you'll learn the important factors that you need to know to create a system or have the skill in place to modify an existing system to fit your own style.

In the Blueprint Workshop learn to develop your own personal roadmap with the help of an experienced guide. Some people take years to discover just a portion of what you are going to learn in a 3-day period.

To see the schedule, including dates, prices, combo discounts and location, click here.

The Proper Order for Trading Preparation..Among Other Things

Q: I am a subscriber to your weekly newsletter.  I have also read and re-read each of the following books a number of times;

•              Trade Your Way;
•              Safe Strategies;
•              Super Trader; and
•              The Definitive Guide to Position Sizing

I recently downloaded and completed all 10 levels of the Position Sizing Game (albeit on the ‘easy’ mode).  I did not go bankrupt once, and whilst I did not progress through each level on the first attempt my account was always profitable at the end of 100 trades, and on level 3 I progressed with a 500% gain. My account total at the end of level 10 was $38 Million.   I was able to cascade through these levels reasonably quickly by applying the principals outlined within the Definitive Guide to Position Sizing as follows:

1. Using the SQN score for each level to establish the Maximum Portfolio Heat, as well as to limit the downside potential on my original capital (for each level), by using a small bet size.

2. When in a profitable position I used the portfolio heat to establish a maximum bet size on my winnings (i.e. markets money technique), and I combined this with my original capital small be size.

I have a history of failure in the real markets. I have tried stock and options trading in the past, however I realize that I  never had a system and approached it with a gambling mentality.  Through the Van Tharp products I have developed an understanding of the importance of issues surrounding exits, position sizing, R-Multiple distributions, starting capital, SQN scores for system evaluation, setting objectives, and my next goal is to be able to design and trade some of my own systems.  I have read in some of your publications that it is fairly easy to design quality systems for each of the market types, however I still do not know how or where to start in this process of system design.  This obviously means that I have more work to do, and I guess I am seeking some guidance from the Van Tharp Institute on what the next stage of my development in this area could/should encompass so that I can work towards achieving my next goal.

On a separate matter I read with interest Model 15: Scaling in Techniques (in Definitive Guide to Position Sizing). The reason this interested me is because it seems that if you have a few winning trades happening and you apply a form of scaling in at different levels, then this has the potential to substantially increase the expectancy and SQN of a system, without having to look elsewhere for great trading opportunities. i.e. you can create multiple great trading opportunities from just one initial trade, because your winnings will not just be based on your initial position, they will multiply.  So for example on one trading stock instead of having a 4R gain (if you did not scale in), you may end up with a 10R gain (if you did scale in).  Am I on the right track with my thinking on this?

I look forward to hearing from you in due course. Many thanks!

—Kimai B., Australia

A: Thank you very much for your business and for your question.  Can I answer for Van? This week, he has a publishing deadline for “Trading Beyond The Matrix”, his latest book.

Congratulations on your success in the position sizing game.  You might consider playing many more times and altering your objectives for the game to learn how to effectively craft position sizing strategies for each—shoot for the moon, go very conservative, etc.

As for developing trading systems, you have a lot of good information already in the Trade Your Way book.  Before you get to that step, however, there are a lot of considerations.  Van stresses putting 50% of your time and effort of planning for a trading business into your objectives.  What are you trying to accomplish?  With great clarity and understanding, can you define it?  Why do you want that goal?  Are you worthy of it? 

Then you have to consider other items as well—What kind of resources and knowledge do you have already?  What are your strengths?  Weaknesses?  How much time do you have?  How will you manage the gambler part of you?  Besides the effects that the gambler part of you has on your trading, what other parts or biases do you have?  How will you deal with those? 

Just to give you a sense of what Van has the Super Traders do so you might see what he believes is the proper order for trading preparation:

1. Complete the Peak Performance home study course,
2. Write a lengthy (>100 pages) business plan
3. Develop three non-correlated trading systems
4. Trade those three systems at a 95%+ efficiency level for >100 trades

Van believes unless a trader understands his psychology at a deep level, then trading may turn out to be an experience of self-sabotage and frustration.  Van actually has most of the Super Trader candidates stop trading for the first three stages of the program so they can focus on their personal and business development.  That’s quite a commitment but this group is very serious about trading well. 

No one has to go through the ST program to trade well—but following through on the major steps of the program probably makes great sense given Van’s extensive research and experience helping traders.  You can take all of the steps basically on your own at home.  But we do have a few workshops (the two workshops in February for example) that would help as well.

As for your thinking on scaling in, you are on a correct track. Trend followers who catch a good move and scale in effectively can make great gains with one good trend.    That also implies being patient and living with (the possible frustration of) long periods of time with many small losses and good drawdowns.  Your psychology matters—some people can do this, many cannot. 

Thank you again and good luck with your Self-development and trading.

Sincerely,

RJ Hixson

Ken's Trade of the Week

In this three minute video, Ken explains why he was not surprised by a series of market moves on the morning of Tuesday, January 15.  The Russell index gapped down at the open, sold off to find support, and then made a direct reversal for a steady climb into lunch. 

Ken’s preparation, execution, and effective position scale ins rewarded him with 10R for this “Trade of the Week”.

http://youtu.be/UExcCf4xUc8 

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