The Van Tharp Institute

September 27, 2006 — Issue #290

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In this Issue:

Workshops

Swing Trading Workshop Dates Announced! December 1-3.

Feature Article

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

Trading Education

Peak Performance for Traders and Investors

Trading Tip

A Review of Market Models— Why Cash Flow is King, by D. R. Barton, Jr.

Listening In...

Comments from the Day Trading Workshop

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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.

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17 Steps to Becoming a Great Trader* October 23- 25 Cary, NC
How to Trade Mutual and Exchange Traded Funds* October 27-29 Cary, NC
Peak Performance 101* November 3- 5 Cary, NC
Peak Performance 202* November 7- 9 Cary, NC
Swing Trading Workshop just added! December 1- 3 Phoenix, AZ

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

Check out our 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 Two

Last week we looked at the randomness bias, which is the tendency people have to seek patterns where none exist and to invent the existence of unjustified causal relationships. 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. This manifests into the "gambler's fallacy" which is a very common trap that traders fall in to and lose money when they do.

This week we will cover the topic of data reliability and biases that come up in this area. 

Reliability. When people obtain information, they fail to assess how reliable their data is, where reliability refers to the degree to which information reflects what is really happening. What traders observe in the market, with the possible exception of floor traders and other market makers, is not the market, but some sort of visual representation of the market. Thus, you are responding to a bar chart or a candlestick chart, or a point and figure chart, or to a representation of the market profile, etc.—and not to the real market. Furthermore, few people make decisions from that information alone. Instead, they distort the information even more by using indicators. These indicators are essentially shortcuts or heuristics that people have thought up to condense, organize and make sense of the data. Interestingly, there are hundreds of possible indicators—in fact, hundreds of thousands if you count various permutations and combinations—but most traders use only about 20 of the most common ones in their decision making.

Market information is certainly distorted, and thus less reliable, when it is transformed into various indicators. The less reliable the information is, the less value it has for predicting. Using our example from last week when Jack observed patterns in the market, reliability is a measure of how accurately Jack’s pattern actually predicts a sharp move in the market.  Many people might notice a pattern or relationship in the market and then use it in developing a system without ever determining how reliable the relationship is. Accurately knowing how well the pattern predicts the move is very important information for any person wanting to develop a trading system.

A lot of the biases people have in their decision making tend to distort reliability in some way.  For example, we have many biases keeping us from knowing the true probability of an event happening. The true probability refers to the actual probability of the event occurring as opposed to a statistical estimate of the probability from a small sample.

One such bias that keeps people from developing a good trading system is called the representation bias. We tend to imagine that what we see or expect to see is typical of what can and/or will occur. Thus, if you observe a pattern in the market, you expect it to occur. If you develop some concept about the market, you will look for data to support that concept in the market, and you will probably find it whether it exists or not.

Once again, if you do not test objectively, and understand the results of the testing, you will probably find that your observations, in developing a trading system, tend to confirm what you expect to find. Thus, the representation bias is particularly important when it comes to assessing various trading signals. Are you considering the true probability rate in assessing your indicator? That is, are you considering the percentage of time a particular indicator is followed by the predicted outcome? Probably not!

I cannot overemphasize enough that trading indicators are merely ways of representing things of interest. Does a significant chart pattern actually mean that buyers are about to dominant sellers, or vice versa, and produce a significant price change? Of course not!  It merely represents the possibility such an event might occur. Thus, any indicators you develop for buying or selling in markets are your way of representing potential trading opportunities. It is not the opportunity per se. Yet most traders, because of this particular bias, act as if the indicators are what they represent. It is like the indicators (be they stochastic, RSI, or moving averages) start becoming reality, instead of a representation of a concept or a belief in your head. When you realize this, you will become much more attuned to what trading is all about and less concerned about indicators and understanding the market.

Another bias that keeps people from understanding the true probability of an event happening, and thus distorts its reliability, is called the availability bias. We make predictions based upon how available the information is to us instead of the true probability rate in the population. Thus, when you first start looking at the market, the data sample you use will determine what you observe. In addition, strong emotional experiences, which affect how strongly information stands out in our minds, tend to strongly bias our decisions. 

When people start to develop an estimate of how much a trading system can earn in a year or how many winning trades it will have, or any other estimate of its reliability, they tend to start with a set point. They then make adjustments to that figure according to anticipated changes in conditions. The initial set point is called an anchor. The dangers associated with using anchors in our decision making about trading systems (or anything else) is called the anchoring bias

The first danger is that you assume there is some relationship between the anchor and what you are predicting. For example, in order to predict the price of the market a year from now, you would probably start making your estimate with the anchor of today’s price. Over a short period of time it may be an accurate basis for beginning to make an estimate (i.e., today’s price is a good starting price for forecasting the price in two or three days), but over a longer period of time the strategy does not allow for the unpredicted or the unexpected.  That is why one of the most important parts of developing a trading system is extensive planning. And this extensive planning should include a careful consideration of everything that might go wrong.

The second danger in the anchoring bias is that people make an assumption that the initial set point or anchor itself is meaningful. For example, if you use the results of your testing to predict future results, you are assuming that those results are meaningful and will not change dramatically over time. This is probably true if your testing data is different from the data you used to develop the system and included enough samples to make future estimates reliable. But those are big “ifs.”

Another bias that tends to have a significant effect on trading decision-making is hindsight bias. People tend to see relationships in the market after they occur, and then assume they knew it all along. It’s very easy to point out such a relationship after it occurs. I’ve worked with a number of clients who claim that they cannot follow their signals. However, what tends to happen is that they do not recognize the signals while they occur. Instead, they see many possibilities in the data.  But once the signal is complete, it is too late! They then criticize themselves for not taking it when it occurred. The typical response is, “I knew it all along. Why didn’t I take that signal?”

This problem will not occur if you write down your criteria for a signal in enough detail so that it could be entered into a computer.  You can then make a checklist for your signal (or computerize it). Once you do, you will always see a signal when it occurs or the computer will see it for you. Thus, you really will know whether or not you actually knew it all along.

 

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—
Why Cash Flow is King

by

D.R. Barton

Sometimes, traditional ways and practices are best.  For example, respecting our elders is a good thing.  Singing the National Anthem before a ball game is a time honored tradition.  And manners will never go out of style.

But some traditions have worn out their welcome.

Like these traditions, the use of earnings as the main fundamental measure of a company has become less and less useful.

Don’t get me wrong – corporate earnings are still the primary reporting measure used by the press and some analysts.  But a growing number of fundamental analysts are turning the majority of their attention to my favorite measure of corporate health:  cash flow from operations.

Reducing the importance of earnings as a measure of corporate well-being should be the easiest sell in the world – especially after the debacles involving Worldcom, Enron, Global Crossing and others.  All of these companies were “cooking the books”, i.e. manipulating their corporate earnings.  And all of them gave early warning signs in terms of cash flow problems long before the earnings showed any problems.

Cash flow is not impossible to manipulate.  But it is difficult.  And the results that we see in cash coming from operations are so useful (as we’ll see next week) that it’s easy to see that cash flow really is king.

The real problem is that earnings are much easier to manipulate under Generally Accepted Accounting Principles (GAAP) than cash flow.  And this obsession the public has with earnings makes it easier to hide mistakes or even malfeasance.  Worse yet, current mistakes can be hidden for several quarters or even years because of the nuances of accrual accounting.  And unfortunately, that can be long enough for a current management team to collect healthy bonuses and have the problems stay hidden until new management teams come into power.

So what’s a trader or investor to do when the world is shouting about earnings per share (EPS) and you have developed a healthy skepticism for this measure?  Well, if you want to be a fundamental analyst, you have to dig in!  It’s time to pour through the cash flow statements.  They’re right there in the quarterly reports along with income statements and balance sheets.

But take care to limit your review to the hardest area to manipulate:  “Cash flow from operations” or “Cash flow from operating activities”.  There will be other areas of the cash flow statement that include investing activities and financing activities.

Next week we’ll look at a couple of examples of how cash flow can be used to check up on a company’s health.  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...  

Comments From our Recent Day Trading Workshop

"Very good! It has opened my eyes in many aspects of my trading." —Jaroslav Dorda, Czech Republic

"This course provides the essential basics that every person who wants to become a day trader needs to know to have a chance of succeeding. Plus, offers concrete examples of trading systems that provide models of how to develop your own systems based on your beliefs." —Roman Franko, Toronto, Canada

"The course was excellent, well organized, great delivery, very practical, and clear, as well as extremely interesting." —William Trousdell, Florida

"The course was fantastic and D.R. and Brad are excellent teachers. I flew in from Hong Kong for one course and it was well worth it!" —Chris Aiello, Hong Kong

"Provided more than I expected, great introduction to day trading tactics." —R. J. Hixson, North Carolina

"Overall an excellent class. Both speakers are very knowledgeable, both are very honest." —Joel Rosenstock, New Jersey

"Very informative and practical. No fluff, and some outside-the-box thinking was refreshing." —Jeff Jordan, New Hampshire

"Extremely well done course. Great insight into the preparation and execution of a professional day trader's day. I appreciated the combination of rule-based and discretionary approach to trading the same system. Time spent on the 'softer' areas of expectations, and progression of a trading career, financial rewards and skill building were great." —Ed Pomicter, Vermont

Join in the discussions:

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Copyright 2006 the International Institute of Trading Mastery, Inc.

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Quote:

"There is an objective reality out there, but we view it through the spectacles of our beliefs, attitudes, and values." ~David G. Myers, Social Psychology

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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

Oct 23-25 17 Steps
Oct 27-29 Mutual Funds & ETFs
Nov 3-5 Peak 101
Nov 7-9 Peak 202
Dec 1-3 Swing Trading

 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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