Van Tharp's Weekly Newsletter Tharp's Thoughts

"Extremely comprehensive ‘top down’ approach to trading. 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." — T.R.

"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." — J.L.S.

"Excellent ‘drill down’ insights into how Ken uses his indicators. The essence of brilliance is making the complex simple. This course makes a huge step in this direction." — J.S.

June 18-20

~~$3,995~~

$3,295

Systems That Outperform the Global Markets Long Term
(Formerly ETF 101)

June 22-24

~~$3,995~~

$3,295

Swing and Day Trading Systems for Equities and ETFs
(Formerly ETF 202)

Learn More or Register

Notice: You can now save an additional $600 by attending both. With the $700 early enrollment discounts and the combo discount, you save $2,000! Click here to register for both.

The buzz everywhere has been about the crazy market action from last Thursday May 6th.

Many have tried to characterize the day: moves of historic proportions, unprecedented, and, my personal favorite, a 10 sigma occurrence.

The first two are factually accurate. We had the biggest absolute intraday point move in the indexes (there have been larger moves on a percentage basis).

The third observation (10 sigma) is an interesting one. It’s interesting for two reasons: 1) it illustrates how extreme the move truly was, and 2) it shows what happens when we use weak models and unquestioned assumptions.

The concept of 10 sigma events was popularized by Roger Lowenstein’s excellent book When Genius Failed: The Rise and Fall of Long-Term Capital Management. Lowenstein recounts that their models showed that the loss LTCM suffered was a 10 sigma event, meaning that it should statistically happen only once every 1 × 1024 days—which means never.

Most people assume this refers to a Gaussian or normal distribution. To call last Thursday’s move a 10 sigma event makes that same assumption. This normal model (or set of assumptions), however, does not represent market price activity accurately. Most analysts agree that the market is at best normally distributed with kurtosis (fat tails) and outliers. Some analysts would flat out say that market price activity is not normally distributed. Basically, this is a statistical way of saying that extreme events happen more often than can be predicted or really expected.

Rather than discuss the statistical fine points of big market moves, I’d prefer to provoke some thought about what, if anything, we can or should do given the probability of more wild market moves in the current environment. First, though, let’s see if we can get past the headlines to understand what happened.

What Happened Thursday May 6th?

There is, as of yet, no definitive answer as to what happened last Thursday afternoon. There has been no shortage of solutions offered by everyone from the Securities and Exchange Commission to Saturday Night Live. But as far as specific root causes, not much has surfaced.

The current best guess as to what happened involves a market version of “The Perfect Storm”: many smaller components combined to push the system temporarily off the cliff.

We started the day with the markets down in a big way on fears of a Greek financial demise—the broader damage being done to the Euro and European markets. This push had the Dow down 300 points before the fireworks started. Stop orders started getting hit and the Dow dropped to −500 on the day. Then many things happened in rapid succession, none of which by itself caused the collapse but all contributed:

Investigators and analysts have yet to find the real tipping point. One of early stories circulating (and recounted on American TV’s Saturday Night Live sketch comedy show) was that a trader “fat fingered” a sell order for $16 billion of S&P e-mini contracts instead of $16 million. This story and other similar ones have largely been discredited.

Today’s stock market game is different than some years back. After regulations changed (Reg NMS provided open data access to all exchanges), the volume on many blue chips has dropped from 80% on the NYSE just a few years ago to less than 30% today, according to the Wall Street Journal. That means that the majority of trading for P&G, IBM and other household blue chip namesis now goes through the NASDAQ, BATS and other electronic exchanges.

After some experience with market crashes, the NYSE designed trading “circuit breakers” to help relieve some of the problems of fast moving prices. They work fine in theory but today the problem is that more blue chip volume flows through the electronic exchanges—which don’t have circuit breakers systems. What’s apparent now is that the circuit breakers on the NYSE actually exacerbated the problems last week rather than relieved them. Certainly more cooperation and common circuit breaker rules among the exchanges will be one of the outcomes of this chapter in the trading annals.

In addition, estimates reported by the WSJ are that 30% of total stock trading volume is now done by high frequency trading firms. Whether you think they are champions of a free market economy, parasites on society, or something in between, I can’t imagine that the trading firms behind that much volume will be allowed to play along with business as usual in the future. At minimum, some rules concerning market participation are likely to come up so that the liquidity from these channels doesn’t just dry up at the flip of a switch.

Before diving deeper, I want to scan the 30,000 foot view for just a moment. Lots of funds and many, many retail investors and traders got hurt when stop losses were triggered (almost universally at unfavorable prices with bids drying up). Then with big losses on the page, the markets climbed back in a matter of minutes leaving many perplexed and shell shocked at how they could lose huge money while following the rules of prudent investing and trading and using stop losses.

Fair trading markets are a cornerstone of any modern society. And Thursday’s market gave at least an appearance (not the reality) of being an unfair game that the average investor or trader can’t win. In trying to rectify this situation, let’s hope the regulation pendulum doesn’t swing too far in the direction of control.

Regardless, as traders and investors, the relevant question of the moment is “What do we do about it?”

I’ve heard lots of discussion, especially around stop losses. And I’ve been asked these questions:

Proper position sizing remains the MAIN source of risk management for traders and investors. Realizing a loss two or three times bigger than our planned risk amount (-2R or -3R in Van’s terms) should not put our accounts in jeopardy if you have even an inkling about risk management.

Additionally, everyone needs to have some exposure to low correlated positions. If you mainly trade and invest in stocks, consider trading gold and other commodities as well. Even if you had multiple holdings that were completely uncorrelated, each and every one of them requires proper position sizing! Remember, there were almost no safe havens in the fall of 2008.

Let’s finish up by putting last week into perspective. A 10% drop in one day certainly is ugly—but it’s not disastrous. Even if you got stopped out at the bottom of the spike down on Thursday afternoon, you live to trade and invest another day.

Next week I’ll review the thorny issue of intraday stops versus close only stops and try to shine some light on the increasingly difficult trade-offs between the two. Please remember: protecting yourself with stops is still a central part of good trading practice. One event does not make a trading and investing career! Until then, I’d love to hear your thoughts and feedback at drbarton “at” iitm.com.

About D.R. Barton, Jr.: 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 "iitm.com".

Learn the Best System Development Practices from Two of the World's Finest System Development Minds, Van Tharp and Chuck LeBeau

The average person doesn’t have a chance at profitable trading because they concentrate on all of the wrong things. Through this program, Dr. Tharp helps you determine what type of trading system suits you personally, understand what all of the parts of a trading system are, and create each part for a complete system. Chuck talks about a number of technical topics including the ADX indicator, chandelier exit strategies, and his moving average crossover research.

Or, Even better... Buy the System Development Home Study AND the Peak Performance Home Study Together for only $1,400.. Click for more...

While Everyone Was Nervous,
One Great Trader Took 100R from the Market Last Week

Ken Long is one of our best instructors at The Van Tharp Institute and he may have reached "master" status given his consistent performance over the long run and recent outstanding results. Ken always teaches the traders in our workshops to manage the left side of the trade—risk. Sometimes the right side (reward) works out okay and sometimes it works out fantastic, but the focus is always on managing the risk. He did that last week as he always does even as everyone else was concerned about the chaos. We even had one person tell us that he would never keep stops again because he was stopped out of everything on Thursday. Well, in that same week, Ken managed to make 100R.

Let’s look at how he did it. After a large multi-day move down that started about 8 trading days back ($74 range), Ken believed that a stock on his watchlist had overreacted and there was a chance one morning midweek last week that there could be a bounce back up. As he likes to say, “The market never reacts when it can overreact." Ken was watching for signs of a strong bounce up after the open - a very low risk entry. When he saw it, he went long on it for the first time just before 10 AM. As a result of the strength of the move, he entered four times that hour, maintained his normal risk controls and was able to pull 60R out of one trade. That’s truly phenomenal.

In another notable trade last week, Ken pulled in 22R. In addition to his other winning trades (and a few losses, too), Ken finished at 100+R for the week.

Ken fully acknowledges that his results were beyond the range of “normal.” In his own words,

While many of you are scared of this market, I have been saying for some time that the wild markets ahead present numerous opportunities.

Ken Long will be presenting two workshops in June for the Van Tharp Institute. If you want to know how Ken trades and the specifics of his 100R week, be sure to attend.

About Van Tharp: Trading coach, and author, Dr. Van K. Tharp is widely recognized for his best-selling books and his outstanding Peak Performance Home Study program— a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at www.iitm.com.

Mailbag

Technical Research Not Resulting in Profits

Q: I have been providing technical stock research to institutional money managers for 20 years. I am very good at reading trends and trend dynamics. While this analysis has helped my clients significantly over the years, I have not been able to translate this analysis into consistent profits in my personal trading. Do you have any general advice for someone in my position?

A: Well, fundamentally you can spot when things are out of alignment, but you need to do the following:

Get your psychology in order so you stop making mistakes.
Identify your risk when you enter a trade.
Understand how to control your reward to risk throughout the course of a trade.
Understand market types. What you do currently won’t work when market conditions change.
Understand position sizing strategies and their importance in meeting your objectives.
Write a thorough business plan to guide your trading.
Develop several good trading systems. Right now, what you think is your system is actually just your "analysis."

In other words, you have to master a lot more of what we teach.

Van

Ask Van...

Everything that we do here at the Van Tharp Institute is focused around helping you improve as a trader and investor. Therefore, we love to get your feedback, both positive and negative!

Feel free to click below to leave us any comments so that we can serve you better. Or, send Van a question that you would like for him to answer.

Click Here for Feedback Form »

Email Us

Email us [email protected]

The Van Tharp Institute does not support spamming in any way, shape or form. This is a subscription based newsletter.

To change your e-mail Address, click here

Or, paste this address in your browser: http://www.iitm.com/privacy_policy.htm

To end your subscription look at the very bottom, left corner of this email and click on that link. That section will also let you know which email address was used to send the newsletter.

800-385-4486 * 919-466-0043 * Fax 919-466-0408

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

Workshop

Fine Tune Your Trading Skills with the Talented Ken Long

Ask Van...

Email Us