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

• Article The Importance of Position Sizing™ Strategies by Van K. Tharp, Ph.D.
• Trading Education NEW E-Learning from Van Tharp
• Trading Tip Stocks in Your Pocket or Purse: The Market Goes Mobile, Part 4 by D.R. Barton, Jr.
• Workshops 2011 Summer Workshop Schedule
• Mailbag A Position Sizing Game Review

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by Van K. Tharp

John was a little shell shocked about what happened to him over the last three days of volatile market activity—he had lost 70% of his trading equity! He was quite shaken, but he remained convinced that he could make the money back. After all, he had been up almost 200% before the market withered him down to the $4,500 he had left in his account.

What would you tell John at this point if he came to you for advice? Your advice should be, “Stop trading. Get out of the market immediately. You don’t have enough money to trade speculatively, and you don’t understand risk.”

John is very much an average market participant who calls himself a trader. He and people like him try to make a killing in the market, thinking they can turn a $5,000 or $10,000 account into a million dollars in less than a year. This sort of feat is possible, yet making those kinds of returns is highly unlikely while the chance of ruin is almost certain—even if the trader is very smart. Natural intelligence does not seem to help traders with position sizing strategies, which are critical for trading success.

Book Smarts vs. Smart Position Sizing Strategies

Most people would agree that PhDs are smart people. High intelligence, however, seems to be of little or no help in trading successfully. To test this idea, Ralph Vince conducted an experiment using 40 PhDs. (He ruled out doctors with a background in statistics or trading.) They were given a computer game with $10,000 and 100 trials in which they would win 60% of the time. When they won, they won the amount of money they risked in that trial (1R). When they lost, they lost the amount of money they risked for that trial (−1R).

Think about that: you win what you risked 60% of the time and you lose what you risked 40% of the time. That's a positive expectancy system and those odds are fantastic compared with any table you might find in a Las Vegas casino.

Guess how many of the PhDs had made money at the end of 100 trials. When the results were tabulated, only two of the PhDs made money. The other 38 lost money. Imagine that! 95% of the PhDs lost money playing a game engineered to let players win. Why?

Position Sizing Strategies and the Gambler’s Fallacy

Let’s say someone started the game risking $1,000 on each trade and the first three trades all lost. Losing three in a row in a 60% winning game is a distinct probability. Now this participant is down to $7,000. He thinks, “I’ve had three losses in a row, so I’m really due to win now.” This is the gambler’s fallacy at work. He thinks that there’s a high probability of a winner after several losses. (Your chances of winning on any given trade in this game though are always 60%, regardless of the past results.) He decides to risk $3,000 on the fourth trade because he is so sure he will win. Although the probability of four consecutive losses are slim (i.e., 0.0256), it is still likely to occur once in a 100 trial game. The fourth trade results in another loss. Now he only has $4,000 left in his account and he must make 150% just ot reach break even. Beyond that, his chances of making money in the game have grown very slim. If he kept playing this way, he easily could be broke in a few more turns.

Here’s another way he could have gone broke. If he started out risking $2,500 on each turn, three losses in a row would take his account down to only one more trade of $2,500. There’s a 40% chance the next trade will lose and wipe him out. Additionally, he now must make 300% just to get back to even. At this point, do you think he is more likely to experience a profitable end to the game or bankruptcy?

Nearly all of the PhDs risked too much of their equity in the game. The excessive risk occurred for psychological reasons: greed, the failure to understand the odds, and, in some cases, even the desire to fail. From a purely mathematical perspective, however, their losses occurred because they risked too much money. Had they understood the concept of position sizing strategies, they would have done much better in the game—even if they had some psychological issues affecting their decisions.

Position Sizing Concepts

In a lecture to his students at a 1991 retreat in Hawaii, Ed Seykota said that once you know the expectancy of your system, the most important question a trader could ever ask is “How much should I invest?” Your trading system’s expectancy tells you the probabilities of winning versus losing for each trade and a bit more. Given that information, you can consider your objectives and come up with a position sizing strategy that will help you reach your objectives and answers the question “How much?”

In my opinion, position sizing strategies are the most significant, and yet least understood, part of any trading system. Most individual traders and I would say even many professionals do not understand the importance of this concept. For example, I once attended a seminar for stockbrokers that explained a particular investing method that the brokers could use to help their clients. While the seminar as a whole was terrific, the topic of a position sizing strategy for this method was never covered. In the past, people sometimes referred to position sizing strategies generally as “money management” and one speaker did mention money management briefly. I could not really tell what he meant though, so at the end of his talk, I asked, “What do you mean by money management?” His response was, “That’s a very good question. I think it is how one makes trading decisions.” Well, that’s fine but those brokers walked away from that seminar unable to help their clients with the most important part of a good investing method—knowing how much to risk on each position.

Your position sizing strategy is the part of your trading system that tells you “how much” or “how many” for each trade. How many units of your investment should you put on at a given time? How much risk should you be willing to take? You can’t answer these questions until you understand both your trading system and your objectives. You need to understand what kind of results you can expect from your trading system. Knowing the expectancy and SQN® score of your system can help in this area. You also need clear objectives for your trading and an understanding of what you are trying to achieve—especially in the areas of return and drawdowns. With these two inputs, you can start thinking about your position sizing strategy.

As there are millions of traders with unique objectives, there are millions of variations of position sizing strategies. Aside from your personal psychological issues, position sizing strategies are the most critical conceptual area you need to master as a trader.

Too Much Risk?

Remember our friend John from the beginning of the article? He was up 200% and then down 70% a few days later. We can probably infer that he was risking far too much on each trade. Would you guess he knew anything about appropriate position sizing strategies?

What about you? Are you risking too much on your trades? Do you understand the concept of position sizing strategies? Be sure you do or you risk wiping out your account.

About the Author: 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 vanktharp.com.  

Trading Education

NEW!

You've been asking for on-line courses.The day has arrived!

We're pleased to announce the launch of our first e-learning course:

Introduction to Position Sizing™ Strategies

The information contained in this course will open your eyes to the importance of position sizing strategies and how they can reduce your losses and increase your profits. The profits gained by applying the information contained in this course could easily pay for the course over and over again. 

You'll love the easy-to-follow instructions, with audio, video and interactive features, including Van's famous marble game.

And for a short introductory period, the course is only $99.00!

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Trading Tip

by D.R. Barton, Jr.

In this series, we’re taking a look at mobile phone apps that are available for the iPhone/iPad/iTouch. With a user base of over 100,000,000 iPhones sold, this is the logical place to start our cell phone app review. We’ll move on to the Android platform in a subsequent series of reviews.

Today we’ll review an app called DailyFinance from AOL Money and Finance. Next week we’ll look at CNBC RT (RT = “real time”) from the ubiquitous network. Now on to DailyFinance.

Step Into Our DeLorean: It’s Back to the Future with AOL

For our younger readers out there, AOL (America Online) was once the relevant internet company of its day. It was the undisputed dial-up access king and clearly the single most influential company in spreading the popularity of the internet. AOL’s purchase of/merger with Time Warner in January of 2000 was perhaps the loudest proclamation of the end of the internet bubble.

Fast forward to today: a few years back, Time Warner spun off AOL, leaving it with a few strong internet presences including a popular instant messaging platform. While AOL still has some decent franchises, their financial site called DailyFinance is a faint shadow against the top no-cost financial sites Yahoo! and MarketWatch.

DailyFinance Review

When I first downloaded the DailyFinance app, I didn’t know who published it; I was simply searching for stock market oriented apps without regard to their origin. The app is laid out simply and it’s easy to use; however, one problem keeps it at the bottom of the barrel.

The DailyFinance home page has a good default line-up with its market summary. It takes you through the major stock indexes, 10-year bonds, some global market indexes, and a couple currencies and commodities. The default set gives you a picture of what’s going on in the broad financial markets. The app provides versatility by allowing you to add or subtract issues from this home page list. Watch list and portfolio functions are what one would expect from a functional app performs fine in this area.

Now for what doesn’t work: some historical charting functionality. On the home “markets” page, when you choose the charts tab for any of the markets listed there, it takes you to a default intraday chart. For 8 of the 11 default instruments, however, there’s no data for charts longer than one day. That’s a shame because when you flip your device to landscape, the app makes a very useful and visually appealing gallery of all the instruments from that section (e.g., the 11 default instruments from the market pages). Fortunately, you can see normal historical day charts for any individual stocks that you put in your watch list, but when 8 of 11 markets don’t have any data older than this morning, it renders the charting function relatively useless.

Business Model

There are a few things to note about the app and its business model (I’ll include these types of comments about all of the apps I review). This app is fueled by a banner ad at the bottom of every new page. They are fairly unobtrusive with a unique and interesting twist—after 15 seconds, the banner disappears giving back all of the precious screen real estate.

Next week we’ll look at an app that has some very useful characteristics (like real time data and visually appealing charts). I’d love to hear your thoughts and feedback on this article or about other stock market apps that you’ve found useful.  Please email me at drbarton “at” iitm.com.  Until next week…

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 "iitm.com".

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Mailbag

I just had to let you know I love the game! I was right about the lucky numbers. I have finished Levels 4 and 5 and each time I have “far exceeded” the expectations with a 500% gain on each level. I think the fellow in the game who was cautioning me about taking too much risk was Dr. Tharp—it sounds like the voice I would associate with the pictures I've seen of him; I am very intuitive. Please let him know I have never risked more than 2.1% of my equity on any trade. I just finished Level 5 and am up to $1,373,271!

I hope this doesn’t work like a casino where I get kicked out for taking the house's money. Someone isn’t coming to get me if I start the next level are they?

Seriously, I think this will be a big help to me. I have quickly read a few of Dr. Tharp’s books, so I knew not to over risk in the game. I am going to reread them very shortly to help me put together a real business plan to trade with real money in real life. I am one of the strategic types with great insight: I have some unbelievable technical “innovations” but have all the control issues he describes for strategic traders so well.

I have kissed many toads along the way. Dr. Tharp is the real prince of persuasion that I have needed. I knew when I first read him last year that he “understood me.” Please pass along my thanks for his life’s work.

— A satisfied customer

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