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Tharp's Thoughts Weekly Newsletter

March 26, 2008 — Issue #365
  
Systems

Last Systems Workshop Until November

Article

Systematic Trading: Strengths and (Gasp!) Weaknesses by D.R. Barton, Jr.

Workshops

Many of Our North Carolina Workshops Include a Dinner at Dr. Tharp's Home

Trading Tip

Looking to Duck the Wash Sale Rule? Don’t Use Your IRA by Jim Crimmins

Melita's Corner

Hoarder or Chucker? by Melita Hunt

Systems

Last Systems Workshop Until November 

How to Develop a Winning Trading System April 4-6 Cary, NC

with D.R. Barton and Systems Guru Chuck LeBeau

"This class really provided the mechanics and practical methods of how to create a workable system." — G. Kapraun

"Money and time well spent. The interaction and networking with the group was excellent."  —  S. Hunter

Learn More

 

Feature

Systematic Trading: Strengths and (Gasp!) Weaknesses

by  D. R. Barton, Jr.

There are two distinct instances in my engineering career that I remember more clearly than all the others rolled together.  Both involved pushing the button to start up multi-million dollar chemical plants.  Both involved handling highly dangerous chemicals in extreme conditions.

Processing uranium in a molten (liquid) state is a daunting task.  Uranium is, of course, radioactive.  And that brings lots of complexity with it.   But in our process (taking it from liquid state to solid granules), the chemicals used could also explode.  And that was the less hazardous of the two plants that I started up!  The other involved cracking natural gas and propane at extremely high temperatures (over 1000 degrees) in huge vessels under very high vacuums.

Most memorably, in both cases I was the one single person responsible for “pushing the button.”  Dozens of careers were on the line each time I pushed the button to start up a hazardous process.  And more importantly, literally hundreds of lives were at stake.  If we got things wrong, buildings full of people would die. (After making those sorts of decisions over and over, it’s little wonder that I have no problem pulling the trigger in my own trading!)

My grounding and education in a systematic approach to things was born of necessity; I was in positions where mistakes (at least big ones) were unthinkable.  So we put systems on top of systems to help control the risk.

After all of that, you can imagine that I prefer a systematic approach to the markets.

Systems Trading – The Good, Bad and Ugly

There are a million different ways to look at trading and investing systems.  And people are widely divided in their thinking on systematic trading.  There are folks that think that systematic trading and investing is the only way in the world to overcome our human biases and psychological issues and any other way of trading is doomed to fail.  (The late Bruce Babcock would fall into this camp.)

On the other end of the spectrum are folks that think that any systematic/analytical approach to trading and investing is pure black magic and has no relationship to what happens in the markets.  Michael Lewis espoused this view in his very readable book Liar's Poker

I will say (almost begrudgingly) that somewhere between those two extremes lies the truth.  I have discussed trading with folks in the system and anti-system camps.  Both styles work.  And both have their pros and cons.

In Van’s Peak Performance Home Study Course, he interviews both a systematic and an intuitive trader.  (I’ll stop here to say that if you are at all serious about trading and investing, you MUST do this course.  It is by far the best educational value in the trading/ investing world.)  Van found that the intuitive trader was really quite systematic in how he went about trading.

I have found the same thing in dealing with folks who trade intuitively.  I’ll go so far as to say that all of the intuitive traders that I have modeled or worked with have merely internalized their systems to the point that they implement them at an unconscious level.

Let’s cut right to the bottom line.  Those in the anti-system camp will insist that there is no such thing as a “set it and forget it” trading system.  Their argument is that markets change and market dynamics change in ways that are significant enough that no system can maneuver to keep pace.

And here’s the tough part for a system guy like myself – in the absolute sense, the anti-system folks are right.  I really don’t know of a strategy that has run for decades in a “set it and forget it mode.”   But, before folks go jumping to conclusions, this doesn’t mean that system building is not useful or desirable – quite the contrary.  What it does mean is that systematic traders have to continue to monitor and adjust their trading strategies over time.

And this makes understanding the inner workings of systems design more important, not less!

On the other side of the coin, becoming an intuitive trader or investor is something that takes significant amounts of time, experience, and trial and error.  To develop this style of trading one must be willing to commit themselves to the markets.  There are no real shortcuts here.

There are some real advantages for both the systematic and intuitive style of trading.  Here are a few:

Advantages of Systematic Trading

  • New traders can reach a level of competence more quickly than with intuitive style.

  • Many inputs can be programmed to allow computerized back testing – this can raise a trader’s confidence.

  • When followed with discipline, systematic trading can reduce emotional effects in trading.

Advantages of Intuitive Trading

  • Allows traders to use a broader variety of inputs.

  • Provides opportunities to produce outsized gains in special situations and outlier type events that are not easily captured systematically.

  • Many intuitive traders adapt to changing market conditions more quickly than quantitative models, allowing them to avoid losses or capitalize on changes before a mechanical model can even discern that conditions have changed.

In a series on system trading last fall, I wrote that many professional traders and money managers that I know fall into a category that makes them a hybrid – they have elements of their system that are mechanical and other parts that are rule-based but not necessarily mechanical (meaning that their decision making is repeatable, but not easily programmable).  This combination provides benefits from both sides of the systematic vs. intuitive fence.  The main drawback is that any non-mechanical trading style requires experience to reach suitable proficiency levels.

The bottom line is that for almost all traders and investors, a systematic approach is the best place to start.  Learn how to build mechanical systems.  And equally important, learn how to implement and monitor the performance of those systems.  In the course of learning a highly systematic approach, one can then gain the exposure and experience necessary to identify areas where more subjective rules can be applied.

I really do believe that all successful traders have a rule set that they follow consistently.  Some traders through experience, natural ability and self-mastery are able to have wider latitude on their rules.  And as Van so eloquently reminds us, the most important thing is that you, as a trader, identify your own trading style that fits you best.  This may require some self-work and some trial and error to determine.  But the payoff is lower stress and higher performance trading.

Remember, you can join me and systems guru Chuck LeBeau in Cary, NC for the How to Develop a Winning Trading System That Fits You Workshop, next weekend, April 4-6, 2008.

Great Trading!

D. R.

About D.R. Barton:  A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena.  He is a regularly featured guest on both Report on Business TV,  and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio.  His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at  “drbarton” at “iitm.com”. 

Workshop Schedule

Many of Our North Carolina Workshops Include a Dinner at Dr. Tharp's Home including the upcoming Peak 101 and 202 Workshops.

Attendees enjoy a relaxing break between workshops 
with time to talk to Van, his staff and get to know each other. 

View Fun Photos from One of These Dinners

 

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Peak Performance 101 April 19-21 Cary, North Carolina 

Dinner at Dr. Tharp's Home, Monday, April 21st

Peak Performance 202 April 23-25 Cary, North Carolina 
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Trading Tip

Looking to Duck the Wash Sale Rule? Don’t Use Your IRA

by Jim Crimmins

The wash sale rule, that Gordian knot of trader taxation, just took a few more strange twists and kinks, thanks to a recent, somewhat baffling ruling by the Internal Revenue Service.

At issue was whether a taxpayer can avoid the wash sale rule by purchasing replacement stock inside their IRA (as opposed to buying it personally) within the required 30-day period before or after the sale of a security. 

To this, the IRS now says no dice – if you buy replacement stock inside your IRA instead of purchasing it personally, the taxman says you can’t recognize a loss on the sale. Never mind deferring that loss by increasing the stock basis in his IRA as provided for under the wash sale rule; the IRS says the IRA play eliminates the loss altogether for tax purposes.

Hanging Out with Wash Sales

A wash sale, of course, results when a taxpayer sells a stock or other security and purchases replacement stock that is “substantially identical” within the 30 days before or after the sale. The trader or investor thereby ends up in the same position from which they started – in other words, their trades resulted in a proverbial “wash,” hence the name.

Under the wash sale rule, when a wash sale results in a loss, the investor is prohibited from recognizing a capital loss, something the IRS loathes. Instead, they are allowed to defer the loss by adding it to the basis of the replacement stock, which will either increase any future loss or reduce future gain by that amount. 

In the case under review, a taxpayer sold 100 shares of stock at a loss and repurchased the same stock the next day through his IRA or Roth IRA. The IRS disallowed the taxpayer’s right to declare a loss on the sale and, citing a 1933 tax appeals case, further prohibited the claimant from adding the loss to the basis in the IRA. The result: no loss claim whatsoever, not even deferred.

Wash sale rules are so convoluted and their record keeping so laborious that most traders elect the mark-to-market accounting method to avoid them. Mark-to-market traders are exempt from the wash sale rule because holdings are tallied at year’s end (in other words, marked to market). There is no need to account for gains or losses that might occur within the 30-day wash sale restrictions.

But beware: mark-to-market is not the best move for everyone. For instance, if you are carrying forward a substantial capital loss, under MTM, your gains moving forward would be treated as ordinary income. Because capital losses can only be offset by capital gains, you would only be able to apply $3,000 per year to offset your capital loss. 

Similarly, traders who deal mainly with 1256 contracts often choose to forego MTM “loss insurance” in order to retain their favorable 60% long-term capital gain tax rate on commodities gains.

More Questions Than Answers

Trading within your IRA is perfectly acceptable; it received the green light with passage of the Economic Growth and Tax Relief Reconciliation Act of 2001. In addition to margin trading and short sales, you also can invest your IRA in a wide variety of non-traditional investments, including real estate, deeds of trust, certain business entities and coins.

While the latest IRS resolution certainly seems to close the door on using individual retirement accounts to avoid application of the wash sale rule, it raises questions about which direction the taxman is heading with regard to wash sales in general.

For instance, why would the IRS completely disallow a loss within the context of a statute specifically designed to defer losses? And why would it bring in as supporting argument a 75-year-old appeals court ruling that seems quaint if not irrelevant today?

We may never know. One thing remains clear however: the complex world of trader taxation is a foggy, ill-defined and ever-changing landscape with numerous pitfalls to trip up the ill prepared or inexperienced!

About Jim Crimmins: Jim Crimmins is the founder and President of Traders Accounting. Jim worked with one of the largest and well-known educational organizations of the stock market where he became a master on entity structuring and developed a network of experts in the trading arena. 

Jim has become a nationally known speaker on tax strategies, entity structuring, and lifestyle change. He delivers over 30 talks a year throughout America as well as speaking in several chat rooms each month.  You can learn more at TradersAccounting.com.

IITM Third Party Clause

Melita's Inspirational Corner

Hoarder or Chucker?

by Melita Hunt

While staying here at Mum’s we’ve been purging and rearranging things in her house. She is very open to doing it and actually started the process some years ago, but I don’t think it is easy for her to go through years of collecting to giving it away (Good on ya Mum!).

She has realized that after years and years of saving all type of things for a rainy day; the next 246 years will need to be constantly wet and overcast to actually achieve her goal of using them all (just kidding). Thankfully she has many interests, an array of hobbies and plenty of things to do to keep her occupied for years to come, but when we really started looking, we realized that there were cupboards that had unknowns in them, other cupboards that had “sentimental value” in them (but we couldn’t remember why exactly it was sentimental any more) and others that held “valuable stuff,” which is brought out and used on “good occasions” and has either been passed down or will be passed down to future generations before it eventually turns to dust. We had some funny and some stressful moments over the last few weeks!

Mum and I come from extreme ends of the scale in this regard. I am a chucker (give or take my ridiculously large collections of shoes, coats and books) who likes to have space and orderly cupboards. And in the last twenty years I have completely given up two households of furniture and “stuff” because I moved abroad and just thought that it was easier to give everything away.  What does that say about me? Do I have a mind free of attachment to things or do I not get attached to things enough? I am not sure of the answer. 

One thing that I do know is that there is no right and wrong answer or way of doing things. Unless what you are doing is causing undue stress. 

Mum noticed that she didn’t have room in her cupboards and wasn’t enjoying looking at her cabinets overflowing with bric-a-brac. So she decided to do something about it. Now she has lovely things on display that mean something, her hobbies are neatly organized and labeled, and her spare “items for a rainy day” are currently at the Good Will store waiting for a new owner to use them right now, rain, hail or shine.

And a shift in thinking happened. When do the good occasions happen, when should the “good stuff” be used? Aren’t the good moments located in some way shape or form in each and every day? Isn’t she special enough to be using her “valuable stuff” to enjoy just for the sake of it? We’ve probably all heard of this before and recognize the connection to our “stuff” either in others or in ourselves.  Yet it still stays in the cupboards waiting for its time in the limelight. What causes the shift and the change in actions?

And is there some psychological connection? I have heard that as we let things go, and become less attached to our material possessions, it gives us space inside our head. Does it?

I have been discarding for so long that I don’t notice more space per se, but I do notice a sense of relief and lightness. And I have noticed that as we start to recognize our self worth, we enjoy surrounding ourselves and using beautiful things just because we deserve them. The price of the object becomes irrelevant. You can get the same joy from a $2 piece of art as you can with a $200k piece of art. It’s all perception.

It is lovely to drink from expensive crystal glasses and to eat with Grandma’s cutlery with the pearl handles. And if they happen to break? Well at least it happened while they were being useful and enjoyed.

It is the same with paperwork. How much paperwork, reading or study material do you hold onto with the insane notion that one day you will “get to it?” We accumulate tons of paper that is either immaterial or obsolete, yet we hold onto it thinking that there is some gem of information among the reams. It’s time to let it go. 

If you look around and there is too much stuff to handle. Then maybe it is time for a good old purge. Perhaps you’ll free up some space after all, if not in your mind, then at least in your house.

Melita Hunt is the CEO of the Van Tharp Institute. If you would like to keep up with Melita’s progress regarding her recently diagnosed lung cancer (she is a never-smoker). Please feel free to read her blog at www.myleftlung.com.

You can contact Melita at mel@iitm.com

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