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 is 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
- 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 teaches all of these steps in detail in his various products and workshops.
Van Tharp believes 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.
If you would like to learn more (this is one of Dr. Tharp’s specialties), then we can certainly guide you in the right direction. You just might be surprised at the results!
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!
This is a risk-free purchase. You have 30 days to review, and if the course is not for you, return it for a full refund (minus shipping). You’ll save the cost of the course, $795, with just one idea from this material and learn concepts that will create profit for you for a lifetime!
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 believes that people who understand position sizing and have a reasonably good system can usually meet their objectives by developing the right position sizing strategy.
The Position Sizing™ Game was developed by Dr. Tharp and modeled after his famous marble game that he plays during workshops. You not only learn about position sizing, but you also get to experience how big gains and big losses affect you. This helps you better understand how you might react to real market ups and downs.
As with real trades, there’s only one position sizing™ question to answer: “How much do I risk on each position?” Properly manage your risk and you’ll be on your way to profits. Do it poorly and you’ll blow up your account.
The first levels of the game teach you Position sizing™ strategies and the importance of large R-multiples. If you aren’t familiar yet with how R-multiples work, the game is a great hands-on way to learn. You’ll also work with advanced systems concepts like probability vs. expectancy.
As you progress, the game changes systems, so you can experience what it’s like to trade different probabilities and expectancies. Starting at level 5, you’ll have the option of going long or short on a trade, which means you can go with either the probability or the expectancy. Hopefully, you’ll learn how dangerous it is to bet against the expectancy, even though you get to “be right” more often.
In Levels 6 through 10, you earn big R-multiples by letting your profits run on a winning position. Losing trades happen quickly, but winning trades take time to fully develop. Once a winning trade starts, you have to decide how much to risk. Do you risk only a portion of your profits for a more modest gain or all of them for a shot at the moon? As you play, you’ll learn all about how your emotions affect your trading, which helps you develop discipline.
To complete the game and make it through all ten levels, you have to prove your proficiency in four key areas:
- The importance of R-multiples;
- The difference between expectancy and probability;
- Letting profits run without letting them escape; and
- Using position sizing™ strategies to make sure you have a low-risk trade.
The Position Sizing™ Game is designed to drive these principles home by giving you the experience of making (or losing) money in a safe environment.
Also, these items are all about position sizing:
The Definitive Guide to Position Sizing Strategies: As the title implies this is THE definitive source on the topic. Serious traders use this textbook as an ongoing reference guide for their strategies.
An Introduction to Position Sizing Strategies Elearning Course: Includes audio-visual and interactive learning activities that explain this complicated subject in clear, easy-to-understand terms.
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.
How do you decide how much you should risk on your next trade?
Risk too much and you could blow up your account. Risk too little and a big win won’t even pay for your dinner.
Dr. Tharp’s Introduction to Position Sizing™ Strategies Course includes audio-visual and interactive learning activities that explain this complicated subject in clear, easy-to-understand terms. You will learn the basics of position sizing strategies and the dramatic difference they can make in your results.
Because the course is an introduction to position sizing strategies, it covers the basic material and offers a great start to the process of understanding and utilizing the concepts and includes material on understanding expectancy, including examples.
The book The Definite Guide to Position Sizing covers very extensive material and goes into technical depth in many areas. As its name implies, it is indeed quite definitive. However, some people find position sizing strategies to be a complicated topic and have a hard time grasping and applying the ideas from the book, so we developed this e-course for two primary groups of people: auditory/visual learners who learn more effectively from an instructional format full of interactive features, and those who aren’t really interested in the deeper technical aspects of position sizing strategies but realize that an introduction to the topic would still help their trading.
This course is perfect for busy professionals who need a practical way to understand risk and how to keep losses to a minimum. We see a natural course of study starting with the e-course and then moving up to the Definitive Guide.
You will also learn a lot about position sizing when you play the Position Sizing Trading Simulation Game.
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.
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
In this comprehensive Audio series, you’ll learn all you need to know about setting up a viable business plan for your trading. Van Tharp interviews a variety of special guests and provides you with weekly exercises designed to assist you in preparing your plan as the series progresses.