Tharp Think Concepts

Take The Mystery Out Of Trading

Internationally renowned Trading Coach, Van Tharp taught a set of ideas and principles that he called “Tharp Think.”

These concepts take the mystery out of trading by helping you understand who you are as a trader, how your personal psychology can work for you instead of against you, how to think about and manage risk, and how to develop winning trading systems.

Below is just the beginning of what each concept is about. Take a moment now to read each one to begin your understanding of successful trading the Van Tharp way.

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Psychology Of Trading

Perfectionism, gambling, unnecessary losses, not being able to pull the trigger…

These are just some of the issues that traders contend within the markets every day. What motivates our decisions, and how can understanding what makes our own mind tick help us become better and more profitable traders?

Over the past 25 years, Van K. Tharp has modeled traders and the trading process, seeking answers to questions like, “why do some traders make fortunes while others lose their nest egg?” Dr. Tharp was a trading coach with a Ph.D. in psychology and an NLP modeler. To “model” effectively, you have to find out what behaviors and habits highly accomplished people have in common. Once you identify the common tasks that produce excellent behavior, you need to develop the beliefs, mental states, and strategies that allow you to perform those tasks.

"You do not trade the markets. You can only trade your beliefs about the markets." —Van K. Tharp

What does it mean to say we only trade our beliefs about the markets? Let’s look at some statements and see what you believe about them:

  • The market is a dangerous place to invest. (You are right.)
  • The market is a safe place to invest. (You are right.)
  • Wall Street controls the markets and it’s hard for the little guy. (You are right.)
  • You can easily make money in the markets. (You are right.)
  • It’s hard to make money in the markets. (You are right.)
  • You need to have lots of information before you can trade profitably. (You are right.)

Do you see the theme? Your opinion about each one of these statements is correct, whatever it happens to be. There is no real right or wrong answer. Some people will have the same beliefs as you and others won’t, but that’s not important. What is important is that your beliefs about the markets will direct your thinking and your subsequent actions.

What is a Belief?

Beliefs are a primary way to filter information from the world. Beliefs are judgments, categorizations, meanings, or comparisons. They determine how we perceive reality and relationships in reality. What you expect (i.e. your reality) depends upon your beliefs and they are largely unconscious. Every sentence in this document represents one or two beliefs, including this one.

One of the beliefs that are most productive for good trading is the belief that you are totally responsible for your own results as a trader. When you adopt this belief, then you can learn from your mistakes. However, if you tend to blame someone else (your broker, your spouse, the person giving you tips) or even the market for the results that you get, then you will tend to repeat the same mistakes over and over again.

When traders “own their problems” and assume responsibility for the results produced, they then discover that their results come from some sort of mental state, which either allowed them to 1) follow their rules, 2) not follow their rules, or 3) trade without having any rules.

When traders take the time to write down all their beliefs (about themselves, the markets, money, etc.), then they can establish a much better idea of what they want to trade, how they want to trade and they can also see flaws in their thinking much easier. It is valuable to know which beliefs support you as a trader and which ones hinder your progress.

The Mindset of Trading

Once you have a clear understanding of which beliefs, mental states, and mental strategies are the core factors in top trading performance, you can then teach the same skills to others and have them perform well too. And when you can see this success duplicated in others, which we have been able to do in most aspects of trading, then you know you have a workable model.

The Key Mindsets of Top Traders are:

  • Personal Responsibility
  • Commitment
  • Their psychological “profile”
  • Working on personal issues (e.g., self-sabotage)

What is a Mental State?

Every task has an optimal mental state that will allow you to accomplish that task effortlessly. For example, to execute a trade you benefit from courage and total commitment. Fear, in contrast, is a big disadvantage as a mental state for executing trades.

Mental states are primarily what most people call discipline or emotional control. Examples include: being impatient with the markets, being afraid of the markets, or being too optimistic about the markets.

Controlling your mental states is just part of the answer, but when you can see that you are the creator of your own results as a trader, then you have come a long way and can really make progress.

What is Mental Strategy?

To understand mental strategies, you have to understand how people think. People think in their five sensory modalities, that is, in terms of visual images, sounds, feelings, taste, and smell.

A mental strategy is a step-by-step way in which you use these modalities; it is the specific sequence of your thinking. For example, the most effective strategy for the action step of executing a trade is to 1) see the signal; 2) recognize internally that this is the signal you decided you should take; 3) feel good about it, and 4) take action. If you do anything else, you probably won’t be able to take action or you will be very slow to act.

Trading fundamentals include the Top Tasks of Trading

The first four tasks have to do with preparing for your day.

  • Daily Self Analysis
  • Daily Mental Rehearsal
  • Focus and Intention
  • Developing a Low-Risk Idea

Traders need to be reminded of these tasks and to eliminate any self-sabotage that keeps them from following the tasks.

Van Tharp believed that everything revolves around your beliefs, mental states, and mental strategies, so with that in mind, everything about trading is 100% psychological, including why and how you trade or which system you will follow or build.

Many traders have a hard time “believing” this and it is almost the antithesis of what people learn in academic finance. So only you can decide whether it is worth the time to learn more about yourself and the psychological aspects of trading.

People get exactly what they want out of the markets. Most people are afraid of success or failure. As a result, they tend to resist change and continue to follow their natural biases and lose in the markets. When you get rid of the fear, you tend to get rid of the biases.—Van K. Tharp, Ph.D.

YOU are the most important factor in your trading success! You create the results you want. Going through this home study course, you’ll gain a perspective on the “how” and “why” of your past trading results and learn techniques to increase profits and reduce stress.

Your success as a trader depends on the amount of work you put into applying the principles of the course to your investing and trading. Get started now and take charge of your trading success!

Systems Development

"When I first entered the business of coaching traders, most people thought that a trading system was an indicator."
— Van K. Tharp

There are folks out there who are obsessed with:

  • Finding the stock that will make them a fortune, as though there is some magic way one can actually do that.
  • Developing a trading system to the point of perfection, without ever getting around to actually trading.
  • Finding the ideal “system.”
  • Just looking for someone to tell them what to do.

Do you relate to any of these examples?

Every trader needs a strategy or system to form a framework for their trading. Without a repeatable way to identify and execute trades, you can never be a consistent performer. Basically, your system is a roadmap that guides your trading and keeps you from making decisions when you are least able to do so. Trading can be stressful. It's easy to get distracted. Life goes on regardless of what the market is doing. If you hear news about the market changes, or you're running late for your next appointment, you are not likely to make good decisions about your trades.

But you can't trade just any system. Many people make the mistake of believing that a trading system is something you can just “buy in a box,” something that other people with specific technical skills or secret knowledge of the markets can create for you. It isn’t.

There are hundreds, if not thousands, of trading systems that work, but after purchasing one, the typical trader will not follow it or trade it exactly as it was intended. Why not? Because the system didn’t fit them and their style of trading.

One of the biggest secrets of successful trading is finding a trading system that fits you personally. Developing your own system allows compatibility with your own beliefs, objectives, personality, and edges.

Why You Should Develop Your Own System

You might be thinking, “why should I develop my own system? Isn’t it easier to just go buy a system with proven results?” When someone else develops a system for you, you don’t know what biases they might have. Most system development software is designed because people want to know the perfect answer to the markets. They want to be able to predict the markets perfectly. You can buy software now for a few hundred dollars that will allow you to overlay numerous studies over past market data. Within a few minutes, you can begin to think that the markets are perfectly predictable—a dangerous belief that will stay with you until you attempt to trade the real market instead of the historically optimized market. Many trading accounts have ended up plummeting because of this very thinking. One “sure-thing” trade placed without proper position sizing can wipe some traders completely out of the game.

And what if the person peddling the system is just a great marketer who makes money from selling systems instead of actual trading? How would you know?

In Van’s experience, very few people have really good systems, and over the years, VTI has taught traders what it takes to develop a complete system for themselves. It isn’t rocket science; it just takes commitment and the right knowledge.

You Don't Need a Computer or Math Skills

The idea that you need computer or math skills to develop your own system is one of the biggest misconceptions out there.

Even if you find computers, math or anything mechanical terrifying, you can still determine how and what you want to trade, which is the basis behind developing your own system. In fact, you’re the ONLY person who really knows what will work for you.

The key thing to remember about system development is that the trading strategy is THOUGHT UP by you so that it fits your beliefs, wants, desires and needs. You can hire someone else to computerize your strategy if you can’t do that part yourself; there are plenty of programmers out there who will do it for you. Just remember that not all trading systems even have to be computerized in the first place! In fact, people have designed and tested successful trading systems for years by hand. Computers make things quicker, faster and more efficient, but they aren’t absolutely necessary unless you find that you have to use one in order to feel confident about your trading (if you disagree with this assertion, you probably DO need computer testing to feel comfortable; perhaps you believe that when a computer generates numbers, it is more accurate).

If you truly understand what a trading system really is, this will all make sense. It isn’t complex unless you choose to make it so!

So What is a Trading System?

What most people think of as a trading system, Van would call a trading strategy that consists of seven parts:

  1. Set-up conditions.
  2. An entry signal.
  3. A worst-case stop loss.
  4. Re-entry when appropriate.
  5. Profit-taking exits.
  6. A position sizing algorithm.
  7. Multiple systems for different market conditions (if needed).

The set-up conditions amount to your screening criteria. For example, if you trade stocks, there are 7,000-plus stocks that you might decide to invest in at any time. Most people employ a series of screening criteria to reduce that number down to 50 stocks or less. Perhaps they might look for stocks that are great “value,” or stocks that are making new all-time highs, or stocks that pay high dividends.

The entry signal would be a unique signal that meets your initial screen and that you’d use to determine when you might enter a position—either long or short. There are all sorts of signals that can be used for entry, but they typically involve some sort of move in a direction that occurs after a particular set-up occurs.

The protective stop is the worst-case loss you would want to experience. Your stop might be some value that will keep you in the trade for a long time (i.e., a 25% drop in the price of the stock), or something that will get you out quickly if the market turns against you. Protective stops are absolutely essential. Markets don’t go up forever, and they don’t go down forever. You need stops to protect yourself.

A re-entry strategy. Quite often, when you get stopped out of a position, the stock will turn around in the direction that favors your old position. When this happens, you might have a perfect chance for profits that was not covered by your original set-up and entry conditions. Consequently, you need to think about re-entry criteria.

The exit strategy could be very simple. It is one factor in your trading over which you have total control. Your exits control whether or not you make money in the market or have small losses. You should spend a great deal of time and thought on your exit strategies, for one very good reason: you don’t make money when you enter the market, you make money when you exit the market. Far too many people focus only on market entry, or what to buy, rather than on when to sell. If you approach trading with an exit strategy, it will benefit you right away.

Position sizing is that part of your system that controls how much you trade. It determines how many shares of stock you should buy or “how much” you should invest in any given trade. It is through position sizing that you will meet your objectives.

Finally, you need multiple trading systems for each type of market. At a minimum, you might need one system for trending markets and another system for flat markets. Many professional traders have multiple systems that operate in multiple time frames over many markets to help offset the enormous portfolio dependence of a single trend-following system.

Your system should reflect your beliefs (i.e., who you are as a trader and as a person). Many people are just looking for “any system that works,” but if your trading system doesn’t match your beliefs about the markets, you will eventually find a way to sabotage your trading.

What’s more, most people have never really taken the time to think through what they truly want from their trading in the first place. They don’t have specific objectives in mind. They think they do, but they really don’t. They just have a vague concept in their heads that they “want to make a lot of money,” but objectives are 50% of designing a system that fits you.

Examples of possible objectives:

  • I want to become a full-time trader making 30% per year for my clients with potential losses no bigger than half of that.
  • I want to spend less than three hours a week on trading and get the maximum yield out of my system. While I’d like to minimize my downside, I’m willing to risk whatever it takes to get maximum returns, including losing it all.
  • I want to limit my drawdowns to no more than 20%. I’d like to make whatever I can, but minimizing the drawdowns is my primary objective.

No system is a money-making machine that can be turned on and print cash forever. Systems must be evaluated and revised to adapt to changing market conditions. And while there are ways to measure the quality of the system, you will never trade a system properly if you don’t feel comfortable trading it, just as you might have trouble following the advice of newsletters because you don’t feel comfortable taking certain trades that they recommend.

Improving your trading performance will not come from some indicator that better predicts the market. It comes from learning the art of trading and understanding how to create a trading system that fits your wants, needs, desires, and lifestyle.

So ask yourself, how much time and money am I willing to lose trying to trade other people’s systems?

A great trader asked me once what I wanted my system to do, and I responded vaguely about outperforming the market. He pushed me for the performance statistics I was after, and I told him what they were, but I said that I needed to see what the system would do first. He basically told me that I had it backward. He said very specifically to start with the performance I was expecting and design a system to that specification.—Frank Gallucci

Position Sizing™ Strategies

How many shares or contracts should you take per trade?
It's a critical question, one most traders don't really know how to answer properly.

Position sizing™ strategies are the part 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.

What is Position Sizing?

Van used to refer to this concept as money management, but that is a very confusing term. When we looked it up on the Internet, the only people who used it the way Van uses it were professional gamblers. Money management as defined by other people seems to mean controlling your personal spending or giving your money to others for them to manage, or risk control, or making the maximum gain—the list goes on and on.

To avoid confusion, Van elected to call money management “position sizing™.” Position sizing™ strategies answer the question, “how big should I make my position for anyone trade?”

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 Van believes 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.

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 transaction 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.

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!

We hope this information will help guide you toward a mindset that values capital preservation.

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 a small loss after a 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.—D.R. Barton, Jr.

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.

Van believed that people who understand position sizing and have a reasonably good system can usually meet their objectives by developing the right position sizing strategy.

Where to learn more about this topic
The Definitive Guide to Position Sizing Strategies

For many years, Dr. Tharp specialized in helping traders and investors understand position sizing strategies and how to use them effectively. His Definitive Guide to Position Sizing contains all of this knowledge!

Your success as a trader has little to do with selecting the right investment or even having a great system. Instead, it has everything to do with the “how much” factor when you invest or trade.

Investment professionals have called this factor “asset allocation” or “money management.” However, they fail to understand that the key aspect is “how much” to invest in any position. Others work hard to get themselves a good system but fail to realize that position sizing™ strategies are the key to getting what they really want.

When you have a great trading system, it’s certainly easier to meet your system objectives through your position sizing method, but you can still meet your objectives and profit with an average system if you understand how to properly position size. Yes, your position sizing strategy is that important.

Risk and R-Multiples

To most people, "risk" is an indefinable, fear-based term, usually equated with the probability of losing. Some, for instance, might think that being involved in futures or options is “risky.”

Van’s definition of "risk," however, is quite different.

Knowing when you’re going to exit a trade is the only way to determine how much you’re really risking in any given trade or investment. If you don’t know when you’re getting out, then, in effect, you’re risking 100% of your money.

Van says that risk is the amount of money you are WILLING TO LOSE if you are wrong about the market. More specifically, it is how much you’ll lose per unit of your investment (i.e., the share of stock or number of futures contracts) if you are wrong about the position you've taken.

This is called the initial Risk, or (R) for short.

One of the key principles for both trading and investing success is to always have an exit point when you enter a position. Trading without a pre-determined exit point is like driving across town and not stopping for red lights—you might get away with it a few times but sooner or later something nasty will happen.

In fact, the exit point you have when you enter into a position is the whole basis for determining your risk, R, and the R-multiples (i.e., risk/reward ratios) of your profits and losses.

Your exit point can be defined in terms of points, dollars, or a percentage. For example, William O’Neil says that when you buy a stock, you should get out when it loses 7-8%, while another trader proposes getting out of a stock when it moves 1-2 points against you.

More About Stops

A stop is basically a preplanned exit. Van says that having stops prevents disaster, even though this strongly goes against the grain of the long-term buy-and-hold philosophy.

When the price hits your stop point, you exit the market. A trailing stop basically adjusts that stop when the market moves in your favor, giving you a profit-taking exit as well.

For example, if you buy a stock at $30 and have a 25% stop, you would exit the trade if the price drops 25% to $22.50.

Here’s a trailing stop example: Let’s say you buy the same stock at $30 (with the initial stop at $22.50), but if the stock moves up to $60, your 25% trailing stop would also move up with it and would be placed at 25% of $60, which is $45.

In other words, you would get out of the trade if the stock turned and dropped to $45, but because you bought it at $30, you would have locked in half your profit, or $15. The trailing stop, in other words, moves the exit point in your favor as the price moves in your favor. However, you must NEVER move it backward. Thus, if your stock moves down from $60 to $50, you would still keep your exit at $45, 25% away from the high of $60.

In Van’s opinion, this kind of stop is a safe form of buy-and-hold. You could be in a stock for a long time, but if something fundamental changes, it gets you out.

Let’s use a real-world example. JDSU went from about $12 in February 1999 to a high of nearly $150 in 2000 (prices are adjusted for a number of share splits). A 25% stop would have kept you in the entire move. You would have been stopped out in April of 2000 at a substantial profit. If, on the other hand, you’d used a buy-and-hold philosophy, you would have suffered severe losses when, in October of 2002, the same stock hit a low of $1.58. To break even, the stock would have to rise 800% from current prices, something it may never do in your lifetime. A stop would have totally allowed you to avoid that fall, along with those of other stocks like Enron and WorldCom before they became headlines.

There are many reasons for using tighter stops, and you will probably need to use them for a variety of different trading styles. We are simply suggesting 25% stops as a substitute for the “buy-and-hold” philosophy.

We are not going to get any further into stops at this point because we want to get back to talking about risk. Just remember, you need to know when you are getting out of a position (your exit point or stop) to determine your risk.

More About Risk, or R

To most people, the risk seems to be an indefinable fear-based term that is often equated with the probability of losing; for example, they might think that being involved in futures or options is “risky,” or they may be overly optimistic about the trades they make because they don’t understand their worst-case risk or even think about such factors. Instead, they’re seduced by trading terms like “options,” “arbitrage” and “naked puts,” or they buy into the academic definitions of risk like volatility, which make for good theoretical articles by academicians, but totally ignore two of the most significant factors of success, the “Golden Rules of Trading”:

Never open a position in the market without knowing exactly where you will exit that position, and cut your losses short and let your profits run.

Let’s look at the first golden rule in much more detail to be sure that you understand it. It says that you must always have an exit point when you enter a position. The purpose of the exit point is to help you preserve your trading/investing capital. It defines your initial risk (1R) in a trade.

Let’s look at some examples.

Example 1:

You buy a stock at $50 and decide to sell it if it drops to $40. What’s your initial risk? Your initial risk is $10 per share, so in this case, 1R is equal to $10.

Example 2:

You buy the same stock at $50, but decide that you are wrong about the trade if it drops to $48. At $48, you’ll get out. What’s your initial risk? Your initial risk is $2 per share, so 1R is equal to $2.

Example 3:

You want to execute a foreign exchange trade, buying the dollar against the euro. Let’s say that $100 is equal to 77 euros. The minimum unit you must invest is $10,000. You are going to sell if your investment drops down by $1000. What’s your risk? What’s 1R?

We made this example sound complex, but it isn’t. If your minimum investment is $10,000 and you’d sell if it dropped $1000 to $9000, then your initial risk is $1000, and 1R is $1000.

Are you beginning to understand? R represents your initial risk per unit. It is simply the initial risk per share of stock, or futures contract, or minimum investment unit. Keep in mind, though, that it isn’t your total risk in the position because you might have multiple units.

What's My Total Risk?

Your total risk would be based on your position sizing and how many shares or contracts you actually buy.

Let’s say you bought 100 of the shares in Example 1, which would be 100 multiplied by the share cost of $50 each, giving you a total COST of $5000. However, you are only willing to risk $10 per share, so $10 multiplied by 100 shares = $1000 total risk for this position.

If you bought 100 of the shares in Example 2 at $50 each, your total COST would be $5000, but because you plan on getting out if the stock drops to $48, your total risk is $2 per share multiplied by 100 shares. In other words, you’ll only be risking $200 of your $5000 investment.

Understanding R-Multiples

The next key point for you to understand is that all of your profits and losses should be related to your initial risk. You want your losses to be 1R or less—which means that if you say you’ll get out of a stock when it drops from $50 to $40, you actually GET OUT when it drops to $40. If you get out when it drops to $30, your loss is much bigger than 1R. It’s twice what you were planning to lose, or 2R. You want to avoid that possibility at all costs.

Instead, you want your profits to be much bigger than 1R. For example, you could buy a stock at $8 and plan to get out if it drops to $6, so that your initial 1R loss is $2 per share. If you go on to make a profit of $20 per share, you’ve made 10 times what you were planning to risk—in other words, you’ve made a 10R profit.

You try it:

You buy a stock at $40 with a planned exit at $35. You sell it at $50. What’s your profit as an R-multiple?
You buy a stock at $60 and plan to get out if it drops to $55. However, when it goes that low, you don’t sell. Instead, you just stop looking at it and hope it will go
back up. It doesn’t. It becomes part of the headline business news involving corporate scandal and eventually, the stock becomes worthless. What’s your loss as an R-multiple?

You buy a stock at $50 and plan to sell it if it drops to $49. However, the stock takes off and jumps $20 in three weeks when you sell it. What is your profit as an R-multiple?

Answers

A 1R loss is $5. Your profit per share is $10, so you have a 2R profit.
A 1R loss is $5. Your loss per share is $60, so you have a 12R loss. Hopefully, you can understand why you never want to let this happen.
A 1R loss is $1. Your profit per share is $20, so you have a 20R profit. And hopefully, you understand why you want this to happen all the time.
What’s really interesting is that once you understand risk and portfolio management, you can design a trading system with almost any level of performance. For example, you can design a system to trade for clients that would make about 30% per year with only 10% drawdowns.

On the other hand, if you want to trade your own account and be a little riskier, you can design a system that will produce a triple-digit rate of return as long as you have enough money to do so and are willing to tolerate tremendous drawdowns.

It’s a whole new way of thinking for some, but most successful traders think in terms of risk/reward, which, of course, gives them an edge out there in the markets. Learning to trade and invest in this way will keep you in the game longer and enable you to run with your profits and cut your losses short. What could be better than that?

Expectancy

One of the real secrets of trading success is to think in terms of risk-to-reward ratios every time you take a trade. Ask yourself, before you take a trade, “what’s the risk on this trade, and is the potential reward worth the potential risk?

What can I expect my trading system to do for me in the long term?

What is Expectancy?

A trading system can be characterized as a distribution of the R-multiples it generates. Expectancy is simply the mean, or average, R-multiple generated.

But what does that mean, exactly?

A Brief Overview of Risk and R-Multiples

If you’ve read any of Dr. Tharp’s books, you know by now that it is much more efficient to think of the profits and losses of your trades as a ratio of the initial risk taken (R).

Let’s just go over it again briefly, though:

One of the real secrets of trading success is to think in terms of risk-to-reward ratios every time you take a trade. Ask yourself, before you take a trade, “what’s the risk on this trade? Is the potential reward worth the potential risk?”

So how do you determine the potential risk on a trade? Well, at the time you enter any trade, you should pre-determine some point at which you’ll get out of the trade to preserve your capital. That exit point is the risk you have in the trade or your expected loss. For example, if you buy a $40 stock and decide to get out if it falls to $30, then your risk is $10.

The risk you have in a trade is called R. That should be easy to remember because R is short for risk. R can represent either your risk per unit, which, in the example, is $10 per share, or it can represent your total risk. If you bought 100 shares of stock with a risk of $10 per share, you would have a total risk of $1,000.

Remember to think in terms of risk-to-reward ratios. If you know that your total initial risk on a position is $1,000, you can express all of your profits and losses as a ratio of your initial risk. For example, if you make a profit of $2,000 (2 x $1000 or $20/share), your profit is 2R. If you make a profit of $10,000 (10 x $1000), your profit is 10R.

The same thing works for losses. If you lose $500, your loss is 0.5R. If you lose $2000, your loss is 2R.

“But wait,” you may say. “How could I have a 2R loss if my total risk was $1000?”

Well, perhaps you didn’t keep your word about taking a $1000 loss and failed to exit when you should have. Perhaps the market gapped down against you. Losses bigger than 1R happen all the time. Your goal as a trader (or as an investor) is to keep your losses at 1R or less. Warren Buffet, known to many as the world’s most successful investor, says the number one rule of investing is to not lose money. But that’s not particularly helpful advice for those who are trying to create a meaningful risk framework for their trading. After all, even Warren Buffet experiences losses. A much better version of his rule would be, “keep your losses to 1R or less.”

When you have a series of profits and losses expressed as risk-reward ratios, what you really have is what Van calls an R-multiple distribution. Consequently, any trading system can be characterized as an R-multiple distribution. In fact, you’ll find that thinking about trading system as R-multiple distributions really helps you understand your system and learn what you can expect from them in the future.

Tying it All Together

So what does all of this have to do with expectancy? Simple: the mean (the average value of a set of numbers) of a system’s R-multiple distribution equals the system’s expectancy.

Expectancy gives you the average R-value that you can expect from a system over many trades. Put another way, expectancy tells you how much you can expect to make on the average, per dollar risked, over a number of trades.

“At the heart of all trading is the simplest of all concepts—that the bottom-line results must show a positive mathematical expectation in order for the trading method to be profitable.”—Chuck Branscomb

So when you have a distribution of trades to analyze, you can look at the profit or loss generated by each trade in terms of R (how much was profit and loss based on your initial risk) and determine whether the system is a profitable system.

Let’s look at an example:

Entry Price, Stop, 1R, Actual Exit Price, Profit/Loss

Trade One = $50.00 $45.00 $5.00 $60.00 = 2R gain

Trade Two = $22.00 $20.00 $2.00 $16.00 = 3R loss

Trade Three = $100.00 $80.00 $20.00 $300.00 = 10R gain

Trade Four = $79.00 $70.00 $9.00 $70.00 = 1R loss

Total R 8R

Expectancy (Mean = 8R / 4) 2R

This “system” has an expectancy of 2R, which means that, over the long term, you can “expect” it to make two times what you risk, based on the available data.

Please note that you can only get a good idea of your system’s expectancy when you have a minimum of thirty trades to analyze. In order to really get a clear picture of the system’s expectancy, you should actually have somewhere between 100 and 200.

So in the real world of investing or trading, expectancy tells you the net profit or loss you can expect over a large number of single-unit trades. If the total amount of money lost is greater than the total amount of money gained, you are a net loser and have a negative expectancy. If the total amount of money gained is greater than the total amount of money lost, you are a net winner and have a positive expectancy.

For example, you could have 99 losing trades, each costing you a dollar, for a total loss of $99. However, if you had one winning trade of $500, you would have a net payoff of $401 ($500 less $99), despite the fact that only one of your trades was a winner and 99% of your trades were losers.

We’ll end our definition of expectancy here because it’s a subject that can become much more complex.

Van Tharp has written extensively on this topic; it’s one of the core concepts that he teaches. As you become more and more familiar with R-Multiples, Position Sizing, and system development, expectancy will become much easier to understand.

To safely master the art of trading or investing, it’s best to learn and understand all of this material. It may seem complex at times, but we encourage you to persevere. When you truly grasp it and work toward mastering it, you will catapult your chances of real success in the markets.

System Quality Number (SQN®)

After a number of years researching position sizing™ strategies, Dr. Van Tharp developed a proprietary measure of the quality of a trading system that he calls the System Quality Number, or SQN. The better the SQN score for a given system, the easier it will be to use position sizing™ strategies to meet your trading objectives!

After researching position sizing™ strategies for a number of years, Dr. Van Tharp developed a proprietary measure of the quality of a trading system that he calls the System Quality Number, or SQN.

SQN measures the relationship between the mean (expectancy) and the standard deviation of the R-multiple distribution generated by a trading system. It also makes an adjustment for the number of trades involved. Dr. Tharp has determined that the better the SQN, the easier it is to use various position sizing strategies to meet one’s objectives.

The calculation, use, and interpretation of the SQN are discussed extensively in Dr. Tharp’s book, The Definitive Guide to Position Sizing.

In addition, Dr. Tharp discovered that when he applied the SQN formula to the daily percent price change of a stock or an index, it proved to be an excellent measure of trendiness. Dr. Tharp now calculates a market SQN for the S&P 500 based on the daily changes in the S&P 500 for periods of 25 days to 200 days and publishes the results each month in his free newsletter, Tharp’s Thoughts. Dr. Tharp’s monthly Market Update includes a graphical representation of the market SQN for 100 days, which makes it easy to see how the market is performing. Dr. Tharp also uses a quantitative world model of the markets that shows the strongest and weakest regions, countries, sectors, and currencies using the universe of ETFs. Dr. Tharp’s multiple analytical perspectives provide readers with a holistic view of market conditions and help them understand how the market is likely to perform in the short term.

Minimum System Quality Number

The following is a question about SQN from one of our readers.

Q: Can you advise as to what the minimum SQN would need to be for a system to have a 90% chance of its return being twice as big as its drawdown over a 100-trade period? For example, a 10% chance of a 25R drawdown and a 90% chance of 50R profits over 100 trades. I can then use position sizing methods to get the results I’m after.

A: First, there is no minimum SQN to have a system return twice as much as its drawdown. You can do that with high SQN systems and acceptable SQN systems. “Returns twice as big as a drawdown” is an example of an objective and you achieve your objectives through position sizing, not through your trading system. Your trading system needs to have a positive expectancy, but it is the SQN that determines your potential effectiveness and efficiency in applying position sizing strategies to meet your specific objectives. For systems with higher SQNs, you will find your objectives easier to achieve, you will have more flexibility in choices, and you will be more likely to meet your objective through position sizing methods.

To learn more, I would recommend reading the Definitive Guide to Position Sizing in which I provide a full explanation of the SQN and explain a multitude of position sizing strategies. A number of readers have told us that the book completely transformed their trading by changing how they thought about trading systems and position sizing strategies.

The best traders apply their deep understanding of position sizing methods to a good SQN system and combine that with the proper psychological mindset to make great returns in the market. You too can learn to do that with a strong commitment and the proper training. I wish you the best of luck.

Where to learn more about this topic
The Definitive Guide to Position Sizing™

Your success as a trader has little to do with selecting the right investment or even having a great system. Instead, it has everything to do with the “how much” factor when you invest or trade.

Investment professionals have called this factor “asset allocation” or “money management.” However, they fail to understand that the key aspect is “how much” to invest in any position. Others work hard to get themselves a good system but fail to realize that position sizing™ strategies are the key to getting what they really want.

When you have a great trading system, it’s certainly easier to meet your system objectives through your position sizing method, but you can still meet your objectives and profit with an average system if you understand how to properly position size. Yes, your position sizing strategy is that important.

For many years, Dr. Tharp has specialized in helping traders and investors understand position sizing strategies and how to use them effectively. His Definitive Guide to Position Sizing contains all of this knowledge!

Business Planning

When people choose to trade the markets, they always want to rush in and get started straight away. They foolishly think they are going to miss the next “big wave.” But the market doesn’t know when you get in or when you get out.
So don’t be foolish; take the time to plan. —Mel

Treat Your Trading Like a Business!

The entry price to being a trader or investor is fairly low. All you need is enough money to open an account. Your broker doesn’t care whether you understand expectancy or objectives. Your broker doesn’t care whether you understand that position sizing is the key to meeting your objectives. And your broker certainly doesn’t care that you must have your personal psychology in order for any of this to matter.

Your broker cares about two things:

That you have enough money to open an account, and
That you don’t lose many times the value of your account so that the broker gets in trouble.
That’s it!

You can easily open an account without knowing the first thing about trading.

Is this true of other professions? Can you become an engineer without understanding calculus? Can you become a doctor without going to medical school? Can you be an attorney without passing the bar? Of course not.

Similarly, could you play golf against a pro and expect to win if you’d never before stepped on a golf course? Would you compete in a chess tournament against a master player if you’d never played before? Obviously not, but even if you did, the worst that would happen is that you’d lose a few games (and perhaps a measure of pride).

But what do people lose in the markets? Anything from a few dollars to their life savings, and yet there are no rules about who should or shouldn’t be in the markets.

Day in, day out, people jump into the markets recklessly, without experience, without training, and most definitely without any type of formal plan. In fact, your broker may not even know the real nuances and fundamentals of safe and profitable trading herself. In fact, more often than not, people who open a brokerage account will lose money rather than make it.

If you are serious about being a good trader, you need to approach the practice of trading with the same level of rigor you would apply to any high-level endeavor. The market does not owe you or anyone else great riches. The market does, however, occasionally tease a large number of people with seemingly easy gains (during bubbles and other manias), only to take them away again.

Trading is a business. It’s a profession. It’s a skill you have to learn.

Have a Business Plan

Most businesses fail because they fail to plan.

Business planning is the backbone of success. It shows you where you’re coming from, allows you to organize your thoughts and objectives, and helps you come up with a plan to keep you in the markets and trading successfully for the long term.

Van recommends that traders and investors develop a thorough business plan to guide their trading—even if you’re already trading well.

Your business plan should cover all of the following areas:

  • Your vision.
  • Your purpose.
  • Your objectives.
  • A thorough self-assessment of your strengths and weakness based on real trading logs that you collect (if you haven’t done so already).
  • A thorough assessment of the big picture and the fundamentals that might be behind any trend.
  • A complete understanding of your beliefs about the market.
  • Procedures for getting empowering beliefs and mental states behind you.
  • A documentation of your research procedure for developing new systems and determining how to analyze their effectiveness.
  • Your procedures for developing and maintaining discipline.
  • Your budget and cash flow systems.
  • Other necessary systems such as marketing, back-office record-keeping, etc.
  • Your worst-case contingency plan.
  • System 1—which is compatible with the big picture.
  • System 2—which is also compatible with the big picture.
  • System 3—which might come into play should the big picture change.

If you have all of those things, you have a chance of doing well. Your business plan is a powerful tool that will improve your trading and focus your life.

How to Handle Hot Tips

What happens when someone gives you a tip or an idea about the market? Do you get excited about it and want to act, or do you become skeptical and suddenly distrust the person giving you the tip?

The only correct response to any “hot tip” is to integrate it into your trading game plan to see if it fits. If it does, you can evaluate it further, using your plan’s criteria. If it doesn’t, you can simply discard it. You should never just run out and buy some closed-end Thai mutual fund simply because “Van recommended it.” You should always first consider whether the tips you receive harmonize with your plan.

Van discusses mental rehearsal as one of the ten tasks of trading. The point of mental rehearsal is to determine what could go wrong with your trading plan and determine how to deal with it in your mind. That way, when it does occur in the heat of the moment, you are ready to deal with any distractions that might come up. Think of the tips you receive as possible distractions. How do you react?

This tip is a test in several ways. First and foremost, it is a test of whether or not you even have a game plan.

Do you have a plan that helps you deal with hearing about a “new, sure-fire, can’t-lose” investment? If not, it’s time you developed one. Do whatever it takes to come up with a thorough business plan to cover your trading or investing. Van ranks it among his top requirements for traders.

Every outcome is preceded by a process. You will not make money trading unless you follow a predetermined plan and continually stick to that plan. That’s why you should pat yourself on the back every day if you can honestly say that you totally followed your rules throughout the day. Every “Market Wizard” arrives at that stature by taking one trade at a time. The primary difference between that person and the average trader is that the Market Wizard probably continued to follow his plan every single day. —Van Tharp

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