First edition of the book was published in 1999, this one is the second edition and was published in 2007. In a quite long foreword already there are several good points about trading. Van Tharp tells how everyone trades his or her beliefs about the market and how his beliefs have changed over the course of 7 years since the first edition. The foundation of his trading however, has remained the same in time.
YOU are the most important factor in your success
A trader can come up with trading systems that fit him or her if first becomes aware of the personality. Investors and traders who seek for advice or stock picks are not going to last long in this game. Next level is the search for a winning technical pattern. This alone won’t bring success either cause it takes more than a winning system to become successful. The trader needs internal control that ables to do what professionals do: manage risk, take losses and differ from the crowd. Dr. Tharp suggests trading is 60% psychology, 30% position sizing (money management) and only 10% about technical edge. Most successful investors and traders do something unique.
Judgemental biases
Traders often think that more information about a stock or more indicators on a chart will give them better understanding and higher chances to make money. The fact is there is so much news and information, especially in the Internet age, but human brain can only digest a limited amount of data at a time. It’s easy to get tied to one belief and think all the information is there, while in fact the most important data might just be missing.
Many novices think an entry signal is a trading system. They want to know when to enter the market to make money. Professionals however, work much more on the exit. Proper risk management and exit strategy is what could give a system positive expectancy. Most traders don’t even have any proof about the expectancy of their system.
There are many biases about system development described in the book like representativeness, reliability, lotto, law-of-small-numbers, conservatism, randomness and need-to-understand bias. It gives good ideas about the psychology aspect in developing a trading system. Biases that affect how one tests systems are: degrees-of-freedom, postdictive error and bias of not giving oneself enough protection. Biases that affect how one trades his or her system are: gambler’s fallacy, conservative-with-profits and risky-with-losses, my-current-trade-must-be-a-winner bias.
Setting your objectives
Decide first what you want to achieve in the markets. Your goals need to be realistic. New traders often have unrealistic expectations of making a lot of money with a small account. There is no trading system Dr. Tharp knows about that could have 15 to 1 win ratio and make money consistently. Win ratio of 3 to 1 is already good enough.
Developing a trading system
Van Tharp goes deep into developing a trading system that fits you. Questions you first need to ask yourself and steps to take are described in detail.
Examples of different trading concepts and deciding on which concept fits you: trend-following, band trading, value trading, arbitrage, spreading. The more you really understand your edge, the less you need to backtest it on historical data.
Steps to take:
1. Take an inventory of yourself – your strengths and weaknesses
2. Keep an open mind and gather market information
3. Determine your objectives
4. Determine the concept to trade
5. Think of the big picture
6. Your time frame of trading
7. How to measure what you’re doing
8. What the initial 1R risk will be
9. Add profit-taking exits and determine expectancy
10. The accuracy of R-multiple distribution
11. Evaluate the overall system
12. Position sizing to meet objectives
13. How to improve your system
14. Mentally plan for worst case scenarios
The author with the help of some traders has added explanations of different trading concepts like technical trend following, fundamental analysis for futures markets, value trading for stocks, technical band trading, seasonal tendencies, spreading, arbitrage, inter-market analysis and some other concepts.
There is a chapter about mental scenarios and looking at the big picture. Van Tharp recommends to think about these things monthly: what the home currency is doing, what’s the situation in local economy and other parts of the world, are there regulation risks from the government, possible wars or other disasters, crisis etc.
Six key variables to a great trading system according to Van K. Tharp:
1. Win rate
2. Win / loss ratio
3. Trading fees
4. Trade frequency
5. Position sizing
6. Account size
He goes on with building a trading system. The five phases of entry are general conditions, market selection, market direction, setup conditions and market timing. There is a lot of good knowledge in the book about placing your stops and how to take profits. The author goes through different methods of doing so with examples. One really needs to understand the concept of a particular trading system to decide on the best suitable stop and exit plan. However, it’s essential to have those in a system.
Tharp shows how completely different trading strategies can make money in the same stocks in the same time period using several examples. It’s traders with no system who are bound to lose in the long run. Position sizing is important to meet one’s trading objectives.
Van Tharp wants to make the reader think in R-multiple distribution in regards of expectancy and risk. One doesn’t trade the markets but his or her beliefs about the markets. Also, what a trader gets from the markets is the system’s expectancy minus the cost of mistakes for not following the system. A very interesting point why many traders probably don’t make it.
Of course, there is much more wisdom and educative examples in this book. So if you feel this summary has been interesting, I recommend to read the book. Overall, it has very good content about trading psychology and systems. I enjoyed reading it a lot.
Trade Your Way to Financial Freedom by Van K. Tharp book link
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