Understanding Your Trading System: A Market Edge by Van K. Tharp, Ph.D.

Most people don’t understand that they need a trading system if they are to make money in the markets. Most importantly, that system must fit you, your objectives, your psychology, and your beliefs, for you to be able to trade it effectively.

Furthermore, that system, at minimum, needs an abort signal (when you know you were wrong about the trade), a profit-taking exit, and a position sizing strategy to meet your objectives. Without those criteria as a minimum, you don’t have a system.

Money is made by cutting losses short and letting profits run. It’s made not by being right most of the time, but by always thinking in terms of the reward-to-risk ratio throughout the trade. What is my potential reward right now? What is my potential risk? If the reward-to-risk ratio is not favorable, then you should not be in the trade. That’s why I always recommend that you think of your profits and losses in terms of the initial risk in the trade (or the trade R-multiples). When you understand that your system is characterized by the distribution of R-multiples that it takes on, then you start thinking reward-to-risk, and that’s the road to success in the markets.

For more information about R-multiples, see my YouTube video.

In addition, there are other key aspects to systems. You must know your objectives. What do you expect to achieve with your system? What can you tolerate in terms of drawdowns while you are trading? When you understand yourself, then you can come to terms with objectives that will fit you. When you do that, then you can begin to design a system that fits you, however, most people don’t think about their objectives and thus, they can’t design a system that fits them.

Another key aspect of a system is that you don’t trade the market. Instead, you should trade your beliefs about the market. Until you have useful beliefs or can find useful beliefs, then you won’t be successful in trading. However, even when you have useful beliefs, you still must develop or find a system that fits those beliefs. To try to design or develop a system without knowing the beliefs that it must fit is a recipe for disaster.

For example, suppose you believe that you should buy something when it’s undervalued and sell when it’s overvalued. The first thing you should do with this belief is determine if your understanding of value has any validity. Is it useful? My impression is that most market analysts have non-useful definitions of value when they assess the market value of a stock. For them, determining value is a mental exercise for which they get paid six-figure salaries, but it has nothing to do with the future price of the stock.

Suppose your definition of the value of a stock is the liquidation value of the company. What would it sell for if you could liquidate it in a year? And if you subtract the company’s debt from that amount, is it still a positive value? What’s that liquidation value expressed per share of stock? What if the actual value of the stock is so depressed that it is selling for, say,70 percent of the liquidation value of the stock? Now, that to me is a reasonable definition of value. I talked about this strategy in my book Safe Strategies. Another good definition of value might occur when a stock is carrying some assets on its books at $2 each when their real value is $20,000, and the stock is selling for only book value; again, that translates into real value.

Instead, most analysts determine something like (1) what the value of some new product might be to the company (such as the latest iPhone), (2) what the growth factor of the company would be with this new product, and (3) what price-earnings (P/E) ratio it should command with that growth factor. This, to me, has no real validity, but analysts get paid six-figure salaries to play this game. Who am I to argue with a game that pays so well? You might consider subscribing to some of the e-mails from “Seeking Alpha” for good examples of this. About twenty percent of e-mails I receive now tell me why Apple stock is overvalued and another twenty percent tell me why Apple is undervalued.

If you have beliefs about value that are useful, then you could probably translate them into a reasonable trading system. However, if you have such beliefs, could you buy a stock that just kept going up in price—all the way from $50 to $200—even if according to your definition, it didn’t have “value” at a price of $50? You probably couldn’t because you can only trade your beliefs. Thus, for a system to fit you, you have to assess your beliefs about the market, the usefulness of those beliefs, and whether you can find something that fits those beliefs.

Most people don’t make such assessments. They don’t even understand the impact of their beliefs. Thus they purchase a system and wonder why they cannot trade it — it doesn’t fit them.

Developing Your Edge

You need to understand that a system is a collection of beliefs about the market.

That collection of beliefs should give you:

  • Setup conditions that must exist before you will enter the market.
  • A specific well-defined entry signal.
  • A worst-case exit that tells you when you are wrong about the trade and that defines what a 1R loss will be for you in that trade.
  • Your profit taking exit methodology.
  • Your objectives for that system; those objectives should say something about what sorts of gains you are looking for, what sorts of drawdowns you can tolerate, and the relative probability of each (e.g., you are willing to tolerate a 50 percent chance of a 15 percent drawdown).
  • A position sizing algorithm for meeting those objectives.
  • Last, an understanding of the various market conditions for which you should trade the system and the market conditions for which you should avoid the system.

When you understand your beliefs about each of these parts of a system, then you can run those beliefs through my belief examination paradigm to see how those beliefs affect your trading as discussed in my new book, Trading Beyond the Matrix: Taking the Red Pill for Traders and Investors.

Excerpted from the e-book, “Eight Edges You Must Have”, by Van K. Tharp

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