The Van Tharp Institute

September 20, 2006 — Issue #289

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In this Issue:

Workshops

Many Upcoming Workshops Include Dinner at Van Tharp's Home! 

Feature Article

Biases and Developing Your Trading System, Part One, by Van Tharp

Trading Education

Peak Performance for Traders and Investors

Trading Tip

A Review of Market Models, Fundamental Analysis by D. R. Barton, Jr.

Listening In...

Efficient Market

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Workshops:

 


The Van Tharp Institute is proud to present our upcoming workshops.

Satisfaction Guarantee: We know our workshops are the highest quality available and back them with our 100% guarantee. Attend through noon the second day (that's half of the instruction) and if you are not completely satisfied with the workshop you can still get your tuition back.

Discounts: Register early and save up to $700 on your tuition. Bring a friend who is new to IITM and you each get an additional $200 off, which can be combined with the early enrollment discount for as much as $900 off!

 

Peak Performance and Systems Development  September 23-29 Sydney, AU
17 Steps to Becoming a Great Trader* October 23, 24, 25 Cary, NC
How to Trade Mutual and Exchange Traded Funds* October 27, 28, 29 Cary, NC
Peak Performance 101* November 3, 4, 5 Cary, NC
Peak Performance 202* November 7,8,9 Cary, NC

* These October and November back-to-back workshops include a dinner at Van Tharp's Home. 

These workshops also have combo pricing. By attending back-to-back courses you save even more. 

Learn More...workshop descriptions, dates, pricing...

 

Feature

Tharp’s Thoughts

Judgmental “Heuristics” Or Biases and Developing Your Trading System, Part One

At any given instant, over two billion bits of information impinge upon your senses. Yet consciously, we can only process “7 +or - 2 chunks” of information.  This tremendous reduction in information necessary to act upon external signals or make decisions is accomplished through various “heuristic” rules or shortcuts.

These rules, which are essential if you are to make any decisions at all, are both a strength and a limitation. They offer strength in that they provide tremendous shortcuts to making decisions. Decision-making would be practically impossible without them. However, they are a major weakness because people are unaware they are even occurring or how much they distort and delete information and bias our decision-making. For example, two such biases that make it difficult for most people even to make money in the markets are the gambler’s fallacy and the tendency to be risky in the realm of losses and conservative in the realm of profits—the opposite of what it takes to become a successful trader.

In this three-part article, we’ll explore several of these biases and how they might affect one’s trading and investing decisions.  We will learn about randomness, sampling variability, and data reliability. Today let’s look at randomness and the gambler's fallacy.

The real “secret” to making money in the market has to do with developing an edge in the market by using probabilities and proper money management.  Unfortunately, people have trouble distinguishing between luck and skill when it comes to market predictions. We are unable to comprehend the many factors influencing an event as complex as the movement of a market. For example, if we had access to the number of buyers and sellers in the market at a given time plus information about the conviction and capital behind each trade, we would probably find the markets to be very predictable. Thus, any uncertainty you may have about how the market is going to behave at any given time is in you, not in the market. When you accept the fact that uncertainty is in you, rather than in the market, you will suddenly find you have much greater control over your own behavior towards the market. More importantly, you will have much greater control over the process of designing a trading system and greater understanding of how that trading system works.

When you develop a trading system, you are essentially deciding upon a set of judgmental shortcuts to help you make a decision. Yet people are completely unaware of how we make most of our predictions and judgments, let alone any biases in the way we make them. Thus, the process of designing a trading system is replete with error and becomes a very difficult process. In order to simplify the process, traders need to understand the following major factors:  randomness, sampling variability, and data reliability.

Randomness. People want to treat the world as if they could predict and understand everything. As a result, one of the most significant biases people have is to seek patterns where none exist and to invent the existence of unjustified causal relationships. Traders don’t want to trade probabilities. They want consistency. For example, people fail to understand that a random sequence can include a long string or what would be called a trend. Instead, they try to understand the “trend” as something that it isn’t, instead of accepting that such phenomena occur.

Understanding and trading well are not necessarily the same thing. People don’t understand randomness, yet they expect to be able to understand the market. They then build trading systems out of their attempts to understand the market by identifying unjustified causal relationships without ever realizing they are doing it. It is this expectation to understand markets that leads traders to search for “Holy Grail” trading systems that explain the “underlying order” of the markets. There is nothing wrong with building a trading system based on microcosmic glimpses into how the market might work; but you need to know what you’re doing when you’re doing it.  You are not trying to understand some mysterious underlying order in the markets. You are developing a set of rules whose long term expectancy gives you an edge in the market, while allowing you to withstand the worst possible catastrophe that could occur in the short term.

For example, many people observe a relationship in the market and assume it explains how the market works.

Jack noticed when a particular pattern occurred in the market, it frequently moved 50 to 100 points higher. He assumed the pattern meant that strong hands were moving into the market. And, when the market didn’t follow the pattern, he became very confused. I said, “How often, when you observe this pattern, does the market move like that?”  He responded, “About 35% of the time!”  Thus, Jack had simply observed a pattern that was quite profitable 35% of the time. The rest of the time it had no meaning.

A relationship may occur only 35% of the time, and that may be something you can make money with, but it has nothing to do with being right or trying to explain something. What you must learn is that most trading systems come out of observations that have a certain probability of being correct. Those observations do not explain anything. Remember, a trading system is just a set of rules to guide behavior, nothing less or nothing more. Apparent random fluctuations in the market are caused by many more factors than you can possibly monitor in your system. 

Develop the attitude of following rules
because they give you an edge in the market.
Avoid the need to understand or explain the market.

Because people attempt to understand and make order out of the market, they assume that the longer a trend continues, the more likely it will suddenly turn around. More importantly, traders are usually willing to bet larger amounts of money on that assumption. Thus, traders want to pick tops and bottoms in a trend—a behavior that tends to be as dangerous as stepping in front of a moving freight train, hoping it will stop and turn around just for you. These biases are usually referred to as the gambler’s fallacy. They have resulted in the ruin of millions of traders over the ages. The gambler’s fallacy is one of those biases, which make trading difficult without a system and proper money management. However, traders frequently develop counter-trend following systems because of this bias—usually with disastrous results.

 

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. You can learn more about Van Tharp at www.iitm.com.

Trading Education

Van Tharp's Peak Performance Home Study Course

The Ultimate Home Study Course for Traders. 
  • How to Use Risk 
  • How to Control Stress 
  • How to Control Losing Attitudes 
  • How to Develop Discipline 
  • How to Make Sound Decisions

Contains the five books listed above, and four CDs. 

More Info...

“Your course is the most powerful material I have ever come across on trading. It is challenging and therapeutic for those who want to be better traders and less neurotic in their personalities.” —J.M. 

“A few months ago I purchased your ‘Peak Performance Course.’ I can honestly say it’s the best investment I have ever made towards my career and aspiration to trade my own money from home.” —E. M. 

 

Trading Tip 

A Review of Market Models:
Fundamental Analysis– Company Level

by

D.R. Barton

When most folks think of fundamental analysis, they have visions of analysts locked in dark rooms pouring over company financial statements.  This week, we’ll take a look at this pervasive art, its strengths and its weaknesses.

At its most essential level, fundamental analysis holds the belief that the current price is a reflection of the net present value of all future cash flows.  So directed by this basic assumption, fundamental analysis studies all of the things that can impact the company’s cash flow in the future.

The main tools used in this form of fundamental analysis are the company’s quarterly financial statements.  These include the balance sheet, income statement, and cash flow statement.  Some fundamental analysts become very adept at finding anomalies (both good and bad) in the financial statements.  They then base their investment decisions on the impact these incongruities should have.

Others look at trends in the company’s financials from quarter-to-quarter and year-to-year and then decide if these trends are worth an investment.

Outside of the financial statements, fundamental analysts will also look at key company characteristics like the quality of the management team, new products in the pipeline, and competitive analysis versus other companies in their sector.

So the bottom lines is – does this stuff work?

When done properly, fundamental analysis can be a powerful tool.  Benjamin Graham and his best known student, Warren Buffet, certainly bare witness to this.  But there are several key issues that make fundamental analysis difficult for the average retail investor:

·        Time horizon.  Most fundamental analysts have multi-year time frames.  They expect that their analysis will bear fruit years into the future.  Most retail investors don’t have the patience (or the bankroll) for the time horizon used by Buffett.

·        Capital Requirements.  Most investors also don’t have Buffett’s bank roll.  Developing a diversified portfolio of long-term investment ideas developed through fundamental analysis takes a big portfolio.  The amount of capital required is often overlooked by those who start down this path.

·        Developing an edge.  For the individual, it’s tough to find an “edge” or advantage, when almost all of the fundamental information is widely available.  The individual investor is competing against firms with whole teams of full time analysts.

Because of the patience and capital required, pure fundamental analysis is actually suited to fewer people than practice it regularly.  Make sure that this type of structure fits you before jumping in!  Next week we’ll look at my favorite fundamental analysis tool and see why cash really is king.  Until then, 

Great Trading!

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. 

Listening in...  

www.smarttraderblog.com

September 12, 2006

Efficient Market

I read an interview today in which the person being interviewed commented on efficient markets. Although some people can consistently beat the market, 90% cannot. And what's always cited is Morningstar data which claims that 90% of the mutual funds cannot outperform the market averages so that you are better off with an index fund.

Okay, but let's look at how they define performance. Satisfactory performance is outperforming some benchmark like the S&P 500. And if you cannot outperform it, then staying close is okay. But let's look at the rules: 1) a mutual fund has to remain about 95-98% invested; they cannot go to cash because they don't like the market conditions; 2) the best way to stay close to the benchmark is to own the benchmark -- so they do. So let's say during the year, as a mutual fund, you are about 90% invested in the S&P 500. You give yourself about 3-5% leeway to try to outperform it. However, you also have 1-2% fees that your charge the public. What are the chances of you beating the market. Almost zero!

Thus, the evidence that people support regarding market efficiency is ridiculous.

Also with trillions of dollars, it's very difficult to move in and out of things without moving the market. So big funds, by nature, should have a difficult time beating the market.

However, my belief is that anyone with a million or less could easily double their money each year. It doesn't take real genius to develop a system that could make 100 trades with an 0.8R expectancy, thus giving you about 80R per year in returns. The real genius is being able to be efficient as a human being and actually achieve that return without making mistakes. And if you want to know about mistakes, see my other posts.

Also: 

Participate on our Trading Forum,  a place for traders and investors to share ideas and learn from each other. 

 

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Copyright 2006 the International Institute of Trading Mastery, Inc.

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Quote:

"If you must play, decide upon three things at the start: the rules of the game, the stakes, and the quitting time." 

~Chinese Proverb

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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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Workshop Schedule

Sept 23-25 Peak Performance 101
SYDNEY, AUSTRALIA
Sept 27-29 Systems Development
SYDNEY, AUSTRALIA
Oct 23-25 17 Steps
Oct 27-29 Mutual Funds & ETFs
Nov 3-5 Peak 101
Nov 7-9 Peak 202

 More Info...

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Tharp Concepts 
Explained...

Psychology of Trading 

System Development 

Risk and R-Multiples 

Money Management / Position Sizing 

Expectancy 

Business Planning 

Learn the concepts...

 

 

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