The Van Tharp Institute

May 24, 2006 — Issue #272

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In this Issue:

Workshops

Peak Performance Workshop, 101 and 202 
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Feature Article

Position Sizing,  Back-to-Basics Series

Trading Education

How to Develop a Winning Trading System Home Study Course 

Trading Tip

A Review of Market Models: Elliott Wave Theory,  by D. R. Barton, Jr.

New

Special Report on Money Management now in PDF format

Listening In...

Small Account

Special Reports Reports by Van Tharp: Self Sabotage, Changing Markets

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Feature

Van Tharp's Back-To-Basics Series

Over the next few issues we'll be focusing on a back-to-the-basics series, which some you may have seen in our new site map.

Whether this is the first time or the twentieth time that you have read this core information, it may just give you a new insight or could be a timely reminder. Both are useful. 

Money Management / Position Sizing 

Money management is a very confusing term.  When we looked it up on the Internet, the only people who used it the way that Van was using it were the professional gamblers.  Money management as defined by other people seems to mean controlling your personal spending, giving money to others for them to manage, risk control, making the maximum gain, plus 1,000 other definitions. 

To avoid confusion, Van elected to call money management "Position Sizing."  Position sizing answers the question, "How big of a position should you take for any one 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.

Imagine that you had $100,000 to trade. Many traders (or investors, or gamblers) may 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 it sounded like a great buy, or perhaps they decide to buy 10,000 shares of a single stock because the price is only $4.00 a share (equating to $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. 

Van says that this just shows how important position sizing is.

So 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 only RISK $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 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 (which is $1,000) and 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, you can see how quickly your capital vanishes.

Another thing to notice is that you will be purchasing about $4000 worth of stock.  Work it out for yourself.  Multiply 173 shares by the purchase price of $23.00 per share and you’ll get $3979.  It would probably be around $4000 when you add commissions. 

Thus, you are purchasing $4000 worth of stock, but you are only risking $1000 or 1% of your portfolio.

And since you are using 4% of your portfolio to buy the stock ($4000), you can buy a total of 25 stocks this way 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 very rarely happens. Therefore it is best left on the gambling tables in Las Vegas.

To continue to trade and stay in the markets over the long term, learning position sizing and protecting your initial capital is vital. 

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

Position Sizing—How much is enough?

Start small.  So many traders that are trading a new strategy start by risking the full amount that they plan on using for the long term with that strategy.  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.  Therefore, start small (very small) and minimize the “tuition paid” to learn the new strategy. Don’t worry about transactions 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), then you can begin to ramp up your position sizing.

Manage losing streaks.  Make sure that your position sizing algorithm helps you to reduce the position size when your account equity is dropping.  You need to have objective and systematic ways to avoid the “gambler’s fallacy.”  The gambler’s fallacy can be paraphrases like this: after a losing streak, the next bet has a better chance to be a winner.  If that is your belief, then you will 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 of capital preservation on your journey toward successful trading. 

I have talked to many folks who have blown up their accounts.  I don’t think I have heard one person say that he or she took small loss after small loss until the account went down to zero.  Without fail, the story of the blown up account involves inappropriately large position size or huge price moves, and sometimes a combination of the two. ~D.R.Barton

 

About Van Tharp: Trading coach, and author Dr. Van K Tharp, is widely recognized for his best-selling book Trade Your Way to Financial Fre-edom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors.

Trading Education

Van Tharp's  

How to Develop a Winning Trading System - Home Study Program

Learn the building blocks for designing a trading system that fits your personality and your style of trading. 

This audio series is about giving you the tools you need to design your own system. You will be able to come up with winning systems that will work for you, because they’ll be based on criteria that fit your situation.

The concepts and ideas you will learn could easily improve your trading overnight. 

Learn More about this Home Study Program...

 

Trading Tip 

Trading Tip

A Review of Market Models: Elliott Wave Theory 

by D. R. Barton, Jr.

Last week we talked about the importance of having a “price discipline”. That’s just a fancy way of saying that you have a market model that you trust and believe in.

What market model describes the price action in a way that you understand and accept?

Some people become crazed and rabid fans of one type of market model.  Anyone who doesn’t agree with their price discipline is labeled a heretic.  I tend to find that the more subjective the model, the more fanatic the followers.  But that may just be my personal biases coming out…

For the next few weeks, I’d like to take a look at some of the most prevalent price disciplines or market models and classify them according to my experience with them directly and with those that use them well (or not so well).

Let’s start today with one of the most controversial models and get that out of the way.  Let the gnashing of teeth begin!

Elliott Wave Theory:  Prophetic or Pathetic?

Who would have guessed that the work of Ralph Nelson Elliott would be causing such a non-stop stir 80+ years after it was developed?  But before tackling the controversy, let’s have a quick review.

Elliott Wave Theory (EWT) belongs to a class of market models called cycle analysis.  We’ll take a look at this broader category in another article.  But Elliott theory is differentiated from its cycle brethren by the fact that it doesn’t require absolute time frames between its cycles (or waves).  This is both a strength (since this makes it almost a purely price-based model) and a weakness (because it adds a good deal of subjectivity to the interpretations of the waves).

In simple terms, EWT holds that market prices move up in a five wave pattern and then down in a three wave pattern.  This is a grossly over-simplified but captures the essence of the beast.  If you’d like to learn more, just Google “Elliott Wave” and find literally hundreds of thousands of sites interested in helping you out.

So let’s put together a simple rubric to use in evaluating our market models: 

Is it theoretically credible?

Who is it most useful for?

Is it being used by real-life traders?

For fun;  How fanatic are its fans?

Is it theoretically credible?  The basis of markets moving in cycles is pretty clear and repeatable.  Elliott was clearly influenced by Dow’s work and the basis for the theory is sufficiently rigorous for trading purposes.

Who is it most useful for?  The tongue-in-cheek answer: those with a thick skin, a flexible outlook and a high level of creativity.  The more serious answer is that most serious traders should have a basic understanding of Elliott principles because it does give a useful interpretation of the market’s general “three steps up, two steps back” movement pattern.

Those who do choose to learn Elliott theory will quickly encounter the Achilles heel of this method:  it is an extremely subjective method.  (10,000 Elliott followers just put me on their “hit list” – but please hear me out!)  Because waves have no absolute time constraints, they can be broadly interpreted in real time.  (Everyone gets it right looking back on moves that have already happened). 

BUT…

Those who gain experience with this method can become very proficient at making high quality decisions.  See the “real-life traders” section below.

If you like the concept of Elliott theory, but want to minimize the subjective issues, you might try out a few of the software products that are out there.  They don’t all agree on the wave counts, but you can find one that aligns with your interpretations and then stick to it.

Is it being used by real-life traders?  With the seemingly negative outlook presented, be prepared for a shocker.  The answer is a resounding YES.  I have several good friends who are excellent Elliott analysts and I have read the work of several other very good Elliott analysts.  A general statement that can be made is: "When experienced traders and market observers combine that experience with a useful price discipline, they are generally successful."

As with all of the market models we’ll review, the usefulness of the model may have something to do with how many people are using that model and reacting to the price levels that it produces.  But whether the model is a self-fulfilling prophecy or a real reflection of the underlying structure of the markets, if it works consistently, then it is useful.

Great Trading!

D. R.

D. R. Barton, Jr. is the Chief Operating Officer and Risk Manager for the Directional Research and Trading hedge fund group. D. R. has been actively involved in trading, researching, and teaching in the markets since 1986.  D. R. has taught extensively in many investment areas including intra-day trading, swing trading, and cutting edge risk management techniques. 

His writing credits include co-authoring Safe Strategies for Fin-ancial Fre-edom and co-creator and contributing author on Fin-ancial Fre-edom Through  Electronic Day Trading.

D.R. presents the IITM Swing Trading Workshop and Professional Tactics for Day Traders Workshop. Each workshop is only held once each year. 

 

New

Van Tharp's Special Report on Money Management

Now available in PDF downloadable format!

$79.95 with no additional shipping charges for PDF files

You will learn...

• 27 models of position sizing with three ways to measure equity

• How to design high reward risk systems for money management

• Four techniques to produce maximum profits

• How to meet your objectives with position sizing

• Optimal position sizing techniques

• Understanding total, core, and reduced total equity models

• Using group and portfolio heat.

• Generalize "turtles" position sizing techniques

• Market Wizard position sizing techniques

• How to maintain constant risk

• How to maintain constant volatility

• Margin based position sizing

• Equal leverage models.

Learn More...

 

Listening in...  

Small Account 
Author: jproctor
Date: 05-11-06 04:50

I have purchased all three books which I found fantastic and the first one that I purchased saved my A!!! What happened is I purchased an ISA (I live in the UK) which was supposed to be a safe investment (ha ha) which then through the crash (2000) went from £5000.00 to £900 (Oh bugg!!). Also, I was playing with day trading but using strict position sizing. I didn't loose any money. It made me stay out most of the time. The question is, I only have a small account $4300.00. Is there any way that I could trade/develop a system with such a small account, I don't know if there has been any new techniques or methods to allow this.

jproctor

Reply To This Message 


Re: Small Account 
Author: PMK
Date: 05-11-06 08:26

I suggest you tackle this the other way around (you have it back to front) - don't create a system that's designed to trade only a $4,300 account, but research, create, and test a system that will meet your objectives for return and risk and then see how much cash you need to trade it.

Then save the required amount of cash (you managed to save $5,000 for your ISA and $4,300 for your trading account, so just do more of the same while you are developing your system).

For the benefit of the American readers:

"Back to front" (UK) = "a**-backwards" (US)

Paul King

Reply To This Message 


Re: Small Account 
Author: Andrew
Date: 05-11-06 17:06

If you are in the UK you can trade through a spread betting account which normally has a very low minimum account requirement; you certainly have enough to open one if you wish.

If you decide to do this, you may find that you will have to devise a system specifically designed to spread bet; for example you will not be able to place a stop within the spread quoted by the company or you may be limited in your choice of instruments to trade, which are restrictions you will have to factor into your system design. However, an advantage of spread betting is the very small risks you can take, as little as GBP 0.5 per tick, which lends great versatility to any possible position sizing algorithm, and again will have ramifications for your system design. 

Participate on Van's Trading Forum, 
a place for traders and investors to share ideas and learn from each other

To read more posts on the above subject, look for the heading, Small Account

 

Special Reports By Van Tharp

Click below to read page one of each report, or to order. 

Self  Sabotage - Two Reports of Self Sabotage

Does Your System Still Work in Changing Markets?

 

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Copyright 2006 the International Institute of Trading Mastery, Inc.

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Quote of the Week:

The most important rule of trading is to play great defense, not great offense. Every day I assume every position I have is wrong. I know where my stop risk points are going to be. I do that so I can define my maximum possible drawdown. 

Paul Tudor Jones

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Free Trading Simulation Game

A computerized version of Van's famous "marble game." 

It is designed to teach you the important principles of proper position sizing. 

Download the 1st three levels of the game for free. Register now. 

 

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2006 
Workshop Mini-Schedule

June 3-5 Peak 101
June 7-9 Peak 202
Jul 14-16 You and Your Money
Aug 25-27 Systems Development
Sept 16-18 Day Trading
Sept TBA SYDNEY, AUSTRALIA
Oct 23-25 17 Steps
Oct 27-29 Mutual Funds & ETFs

 More Info...

 

 

 

 

 

 

 

 

 

 

 

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