Tharp's Thoughts Weekly Newsletter (View On-Line)
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Article Why Size Matters (Why Position Size?) by Van K. Tharp, Ph.D.
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Now Taking Pre-Sales!
New, Second Edition, The Definitive Guide To Position Sizing Strategies!
We are expecting delivery of the new Second Edition books from the printer late this week and are now taking pre-sale orders. We will start shipments to purchasers late next week (w/o 16th).
The name Van Tharp is often synonymous with the term Position Sizing. In fact, Van invented and coined the term. It's one of the most important concepts that a trader can understand, yet so often, traders misjudge how critical a role it plays in your results. To help traders, Van set out to create the definitive compilation of this weighty subject some years back. Based on the feedback from the book’s first edition readers, he was quite successful and now he is releasing the second edition.
If you think your systems are more important than your position sizing strategies in meeting your objectives, we strongly encourage you to study this book. Understanding position sizing topics will have more impact on your trading results than any other single “technical” subject. After reading it, you'll understand why many traders keep the book close by as desk reference.
It's a substantial book, well worth its $249 price tag, however, during our sale you can get the NEW edition for $199!
Learn More
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Article
Why Size Really Does Matter!
by Van K. Tharp, Ph.D.
View On-line
How many shares or contracts should you take per trade? It's a critical question, one that most traders don't really know how to answer properly.
Position sizing™ strategies are the parts of your trading system that answers this question. They tell you “how much” for each and every trade. Whatever your objectives happen to be, your position sizing™ strategy achieves them. Poor position sizing strategies are the reason behind almost every instance of account blowouts.
Position sizing is the part of your trading system that tells you “how much.”
Once a trader has established the discipline to keep their stop loss on every trade, without question the most important area of trading is position sizing. Most people in mainstream Wall Street totally ignore this concept, but I believe that position sizing and psychology count for more than 90% of total performance (or 100% if every aspect of trading is deemed to be psychological).
Position sizing is the part of your trading system that tells you how many shares or contracts to take per trade. Poor position sizing is the reason behind almost every instance of account blowouts. Preservation of capital is the most important concept for those who want to stay in the trading game for the long haul.
Why is Position Sizing So Important?
Imagine that you had $100,000 to trade. Many traders (or investors, or gamblers) would just jump right in and decide to invest a substantial amount of this equity ($25,000 maybe?) on one particular stock because they were told about it by a friend, or because it sounded like a great buy. Perhaps they decide to buy 10,000 shares of a single stock because the price is only $4.00 a share (or $40,000).
They have no pre-planned exit or idea about when they are going to get out of the trade if it happens to go against them and they are subsequently risking a LOT of their initial $100,000 unnecessarily.
To prove this point, we’ve done many simulated games in which everyone gets the same trades. At the end of the simulation, 100 different people will have 100 different final equities, with the exception of those who go bankrupt. And after 50 trades, we’ve seen final equities that range from bankrupt to $13 million—yet everyone started with $100,000, and they all got the same trades.
Position sizing and individual psychology were the only two factors involved—which shows just how important position sizing really is.
How Does it Work?
Suppose you have a portfolio of $100,000 and you decide to only risk 1% on a trading idea that you have. You are risking $1,000.
This is the amount RISKED on the trading idea (trade) and should not be confused with the amount that you actually INVESTED in the trading idea (trade).
So that’s your limit. You decide to RISK only $1,000 on any given idea (trade). You can risk more as your portfolio gets bigger, but you only risk 1% of your total portfolio on any one idea.
Now suppose you decide to buy a stock that was priced at $23.00 per share and you place a protective stop at 25% away, which means that if the price drops to $17.25, you are out of the trade. Your risk per share in dollar terms is $5.75. Since your risk is $5.75, you divide this value into your 1% allocation ($1,000) and find that you are able to purchase 173 shares, rounded down to the nearest share.
Work it out for yourself so you understand that if you get stopped out of this stock (i.e., the stock drops 25%), you will only lose $1,000, or 1% of your portfolio. No one likes to lose, but if you didn't have the stop and the stock dropped to $10.00 per share, your capital would begin to vanish quickly.
Another thing to notice is that you will be purchasing about $4,000 worth of stock. Again, work it out for yourself. Multiply 173 shares by the purchase price of $23.00 per share and you’ll get $3,979. Add commissions and that number ends up being about $4,000.
Thus, you are purchasing $4,000 worth of stock, but you are only risking $1,000, or 1% of your portfolio.
And since you are using 4% of your portfolio to buy the stock ($4,000), you can buy a total of 25 stocks without using any borrowing power or margin, as the stockbrokers call it.
This may not sound as “sexy” as putting a substantial amount of money in one stock that “takes off,” but that strategy is a recipe for disaster and rarely happens. You should leave it on the gambling tables in Las Vegas where it belongs.
Protecting your initial capital by employing effective position sizing strategies is vital if you want to trade and stay in the markets over the long term.
People who understand position sizing and have a reasonably good system can usually meet their objectives through developing the right position sizing strategy.
Position Sizing—How Much is Enough?
Start small. So many traders who trade a new strategy start by immediately risking the full amount. The most frequent reason given is that they don’t want to “miss out” on that big trade or long winning streak that could be just around the corner. The problem is that most traders have a much greater chance of losing than they do of winning while they learn the intricacies of trading the new strategy. It's best to start small (very small) and minimize the “tuition paid” to learn the new strategy. Don’t worry about transactions costs (such as commissions), just worry about learning to trade the strategy and follow the process. Once you’ve proven that you can consistently and profitably trade the strategy over a meaningful period of time (months, not days), you can begin to ramp up your position sizing strategies.
Here's what our friend and colleague D.R. Barton said about it: "I've talked to many folks who have blown up their accounts. I don’t think I've heard one person say that he or she took small loss after small loss until the account went down to zero. Without fail, the story of the blown-up account involved inappropriately large position sizes or huge price moves, and sometimes a combination of the two."
Manage losing streaks. Make sure that your position sizing algorithm helps you reduce the position size when your account equity is dropping. You need to have objective and systematic ways of avoiding the “gambler’s fallacy.” The gambler’s fallacy can be paraphrased like this: after a losing streak, the next bet has a better chance of being a winner. If that's your belief, you'll be tempted to increase your position size when you shouldn’t.
Don’t meet time-based profit goals by increasing your position size. All too often, traders approach the end of the month or the end of the quarter and say, “I promised myself that I would make “X” dollars by the end of this period. The only way I can make my goal is to double (or triple, or worse) my position size. This thought process has led to many huge losses. Stick to your position sizing plan!
This information will help guide you toward a mindset that values capital preservation. This article comes from my Tharp's Concepts material and though many have read it before, it is information that bears repeating...and no better time than with the release of the new Definitive Guide to Position Sizing Strategies, Second Edition!
About the Author: Trading coach and author Van K. Tharp, Ph.D. is widely recognized for his pioneering work in position sizing. He realized years ago that risk management (aka money management) meant many things to different people and just wasn't a useful tool for most traders. He set his goal on developing and then find tuning just how a successful trader could effectively manage risk through the size of the trade placed.
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Trading Education
All Three Peak Performance Workshops Back-to-Back in January!
The Peak Performance 101 workshop is a prerequisite for the Super Trader Program and for the more advanced Peak Performance 202 and 203 workshops. These workshops have been selling out early, so don't let the holiday's distract you. If you'd like to come, register now to ensure you have a seat come January!
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If you live in South Africa and would for Van to host a workshop there, please contact us at [email protected]. There is a possibility he will be visiting South Africa in early to mid 2014.
Click here to see the full workshop schedule or to register.
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Trading Tip
The January Effect —
Another Strategy That Works (With a Twist)
by D. R. Barton, Jr.
The Christmas season is a time of year that has a different vibe, regardless of one’s spiritual leanings. The pace around us quickens, expectations rise, and for those of us who can see past the blatant commercialization that seems to accost us from all directions, some of the joy and love of the season seeps in. I’m looking out my window right now at almost a foot of snow — that certainly seems seasonally correct. Family members are calling to arrange visits for later in month. And we have a few decorations set out that provide a pleasant reminder for our personal reason to celebrate. My kids are coming home from college in just two days; so when combined, I can say that I’m certainly in a state of joy. It’s a nice place to be.
The markets usually manage their own form of “joy” at this time of year as the optimism of the populace seems to bleed over into stock prices. This observation is backed up by the fact that the S&P 500 index has provided positive returns in December in 48 of the last 63 years for a win rate a little above 76%.
Has the January Effect Been Affected by Recent Events?
Many readers will have heard of the January effect where small capitalization stocks have historically outperformed their large cap brethren during the month of January. This was very clear in the second half of the 20th century with Hirsch and Hirsch reporting in the Stock Trader’s Almanac that small caps far outperformed big caps during January in 40 out of 43 years between 1953 and 1995. During that time, small caps gave a staggering absolute performance improvement. The Wall Street Journal reports that small cap outperformance of 5.1% vs large caps during the decade of the 1970s. To say it another way, a $100,000 portfolio invested in small caps would return $5,100 more than one invested in only large caps during the month of January. That’s a huge edge.
Since then, it seems like everyone has jumped on this band wagon and the edge has steadily diminished down to only a 1% edge in the 1990s.
However, there is good news (that is coming up fast upon us) on the small cap outperformance front. The Hirsch father and son team have reported that January effect is still working, it’s just working earlier. Since the 1987 crash, moving the entry date back to December 15th has worked wonders. The numbers show a small cap outperformance from 12/15 to 12/31 of 85% (3.5% vs. 1.9%). The effect remains viable, though weaker if held through the middle or end of January.
And the last two years have built on that outperforming tendency with December of 2012 having a very strong showing for the small caps vs. large caps.
In short, this is a seasonal tendency with a strong track record that is built on a broader foundation of overall market strength in December. Like all seasonals, it won’t work every year, but this one merits a close look and perhaps a trade with your normal risk parameters attached.
Your thoughts and comments are always welcome — please 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
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Mailbag
Mailbag: December 11th, 2013
"Just a quick note to say thank you for yet another brilliant article on Paradigm Shifts for Trading Success.
I find your articles wonderful to read, as much for the things that I agree with as the things that I have to learn from. I just find myself nodding and saying ‘yes’ to so many things that you write.
I am looking forward at some time in the future to participating in your Super Trader program. Thank you for all the work you do to bring success and happiness in life to other people.
Kind Regards,
Tim Walker
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"I have been a trader for many years, trading many different systems. I have followed your work for some time as well. Money Management has saved me more times than I can count. I would definitely be broke if not for that.
I took your online trader test recently and one of the challenges you gave me feedback on was my “Perfectionism”. That hit the nail on the head.
I acquired a new system recently that requires monitoring three charts (3/6/12 min) for multiple setups. I like the system because the setups are clear. What I struggled with was of course having all the setups “PERFECT” before taking a trade. It seemed I could never get ALL the setups perfect. I missed trades and took trades I shouldn’t.
Then a friend suggested “find a reason NOT to take a trade”! What a concept!!
This changed my whole perspective on how to look at the three charts. Now when I look at them, I only have to find ONE setup on any chart that is missing. If I find it, I stop looking and I don’t take the trade. This allows my perfectionism to be satisfied AND it is much less stressful and faster just looking for that ONE missing setup element. I have reviewed many of my past trades, as I document them all, and eliminated a large number of losing trades.
I’m sure you have looked at this approach as well, but I wanted to tell you how grateful I am having the knowledge you have brought me in my life to make me a better trader. I also have your Peak Performance Home Study Course which I have been working through as well. It has helped me be clearer about my day and my approach to trading.
Thank you again Van!
Regards,
Dennis Todd
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