For the seventh interview in the StockTickr Interview Series, I sat down with Dr. Van Tharp, a trading coach and author of several books on trading, most notably Trade Your Way to Financial Freedom and Safe Strategies for Financial Freedom. Van was also featured in the bestselling book Market Wizards : Interviews with Top Traders. Van’s coaching services can be found on his web site.
Dr. Van Tharp’s explanation of money management in chapter 12 of Trade Your Way to Financial Freedom is what inspired me to create StockTickr. I wanted a tool that let me easily calculate the number of shares of a stock to buy given my account size and then track my progress and long term expectancy of my system. The StockTickr Trading Journal does this and has proved to be a valuable tool in my own trading.
Dr. Van Tharp has donated signed copies of Trade Your Way to Financial Freedom and Safe Strategies for Financial Freedom that we’ll be giving away to new StockTickr Pro subscribers. Sign up now to get your free signed copy (while supplies last).
Read on to learn why Van thinks you should never enter a position without knowing exactly where you’ll get out, how it’s theoretically possible to use random entry points and still make money using strict money management principles and a trading journal, and how trading really isn’t that hard.
StockTickr: Tell us a little about yourself.
Van: Okay, I have a Ph.D. in psychology. I think that gave me enough sense to decide after several episodes of losing a lot of money in the markets that the losses might have something to do with me. As a result, in 1982, I began a research project to determine what qualities great traders had (that I lacked).
That same year, the Investment Psychology Inventory was born. Over the years more than 5000 people have taken that test. It does a great job at predicting investment success based upon “where you are now.” But, of course, nothing is set in stone. I’ve seen people who rank in the bottom 10% totally transform themselves.
Anyway, initially about 700 traders took the test and they started asking me, “How can I do better?” I really didn’t know, but I knew how to find out. I became an NLP modeler and started modeling some of the best traders in the world to find out what they did. And over the course of the next five years, I wrote a five volume course on peak performance trading. That course has been the corner stone of our business. I’ve been coaching traders for about 25 years now. I’ve modeled all aspects of trading from discipline, system development, position sizing, and even the wealth process. And we teach it all. There are many, many people that I’ve coached now who have made millions trading the markets.
StockTickr: When did you first start trading stocks and how long have you been involved with it full time?
Van: My first trade was in 1962. I bought 100 shares of a stock at $8. I watched it go to $20 and then down to zero. And on the way down at $4/share and at $2/share, I bought more. I broke every rule that I teach in that one trade. But there are some people who just say I picked the wrong stock. However, I am not a full time trader. I do manage my company’s retirement funds and we do very well. But I’m a full time coach for traders and there is a big difference. If I were a full time trader, that’s all I’d be doing.
StockTickr: Is there a simple trading system you like for the “holy grail” seekers in the crowd?
Van: Let me say this, the system has at most 10% of what it takes to be successful and there are many, many, many systems that work. But with that said, I’ll answer your question. I personally like the efficient stock method that I described in Safe Strategies for Financial Freedom. It’s really simple. You find stocks that are going up in as close to a smooth, straight line as possible. When you find them you buy them. And when they stop going up, you sell them. It’s that simple; and good trading really is that simple.
I also find it very interesting because when I describe my efficiency algorithm, everyone wants to know all the details as though it is “the secret to my success.” No, it’s not. The efficiency algorithm is simply designed to show me a list of stocks. I look over the list to find stocks to meet the criteria I just described – going up in a straight line. Most people, however, won’t accept that and they want to know all the details. However, even if I described all the details I wouldn’t help anyone, because one of the keys to success is that you must find a system that fits you.
StockTickr: Do you ever trade options?
Van: Yes, but options are probably the most dangerous instrument out there. I know more people who lose money trading options than any other area. But option guru’s say it is a way to limit your risk….Yes it is. Your loss is limited to 100%.
StockTickr: Most traders do fine with entry points, but many struggle in exiting both winning and losing positions. What are your suggestions for taking profits (and losses)?
Van: One of the keys to trading is to never enter a position without knowing exactly when you’ll get out of that position to preserve your capital. And if you don’t have a clue where to get out, then you could just use a 25% drop in price for stocks or a 3 times volatility stop for futures.
And any system you have needs to have exits. But again, if you don’t have a clue, you could trail the 25% stop (recalculating it every time your stock makes a new high) or trail a 3 times volatility stop.
Basically, I’d suggest that you write down all your beliefs about exits and then design your exit strategy around your belief. That’s part of the secret of designing a system that fits you.
StockTickr: Do you find that most traders take positions that are too large? Small? What advice can you offer for money management and position sizing?
Van: First you need objectives for your trading system. Most people don’t think about that when they design a system, but it’s probably 50% of system design. The goal of your system is then to find one that gives you a great expectancy and lots of opportunity. Once you have that, then the purpose of position sizing is to meet your objectives. I really can’t make any suggestions about position sizing, because the purpose of position sizing is to meet your objectives. Different objectives require different position sizing algorithms.
However, if you don’t know anything about position sizing, then just risk ½% of your equity per position if you are a beginner or 1% if you know you are making money. But “risk” should not be confused with the actual amount that you are “investing” in the position.
So here’s an example:
Let’s say you have a $50,000. That means you don’t want to risk more than 1% of that or $500 on any given position. Let’s say you buy a $40 stock. You decide that if it drops 25% to $30, you’ll get out. Your risk per share is thus $10. If you divide $10 into your total risk, you’ll get 50. That means you can buy 50 shares of stock. Thus, you invest $2000 in buying 50 shares of the $40 stock. If it drops to $30, you’d get out and your total loss would be $500 or 1% of your account.
StockTickr: What is a reasonable R value to use when trading? i.e. What % of your portfolio should traders have at risk with each trade?
Van: I define R as the risk per position. In the example, about a 1R risk was $10. However, the exact value of R per position will depend upon your system and your beliefs about how you should limit your risk in your system.
If you are using a percent risk position sizing algorithm, then 1R also becomes the percentage of your portfolio that you are willing to risk. I already gave an example of 1%. However, let me repeat myself, your position sizing algorithm is designed to meet your objectives, so what I’d recommend will depend upon your objectives.
And objectives are simply – what are your goals? What are you trying to achieve as a trader? Most people say “I want to make a lot of money” but the more specific you can be about your objectives, then the more efficient you can be about creating the right trading system for you and finding the most effective position sizing strategies to meet those goals/objectives.
StockTickr: Can a winning system be created using completely random entry points if you have a strict money management plan?
Van: You can make money with random entry, but I wouldn’t recommend trading it. I described this in Trade Your Way to Financial Freedom just to make the point that entry was not that significant. But here’s the logic behind my thought.
The rule with random entry is that you are always in the market, either long or short based on a coin flip. And when you get stopped out, you flip a coin and get back in. This means that you have to have a stop that will keep you in the market as long as possible so that you can potentially catch a trend. What seemed to work was the 3 times volatility trailing stop. Combine that with a simple position sizing algorithm like risking 1% per position and you generally will make money. However, you need a lot of money to trade this sort of method. In the futures markets, it required over a million dollars to trade it.
And what’s the point? You can at least say I’ll go long in nice up trending markets and go short nice down trending markets and stay away from flat markets. That’s basically what I do with my efficiency trading method.
StockTickr: It seems like a lot of traders make things too complicated: fancy technical indicators, complex trading systems, etc. Do you think traders would be better served to simplify there trading? How?
Van: Buy what’s going up. Sell what’s going down. Risk about 1% per position. It’s not that hard.
However, you have to have a system that fits you. So write down all your beliefs about the markets — all your beliefs about setups, entry, worst case exits, profit taking exits, position sizing, etc. When you have all the beliefs written down, then design a system that fits you and makes sense. And if you don’t know enough to do that, then it just tells you about your knowledge level. Go read Trade Your Way to Financial Freedom (perhaps several times) and that should give you the knowledge level you need.
StockTickr: Do most failing traders use flawed systems, or do they simply lose faith and deviate from a workable trading system?
Van: They don’t understand what a trading system really is, so in that sense they don’t really have a trading system. And if that’s the case it’s probably a flawed system. In my early days as a coach, most trading systems equated to a set of set-up conditions for entry. For example, people thought CANSLIM (William O’Neil’s set up conditions) was his trading system. And he still doesn’t spend much effort talking about position sizing in that book.
So most people never get a reasonable system. If they do get a reasonable system, then they probably don’t understand position sizing. And if they understand position sizing, then the probably make a lot of mistakes.
Let me explain it this way. Expectancy is the mean R-value of your trading system. Thus, if you have a trading system with an expectancy of 0.75 that gives you 100 trades per year, then you’d probably make 75R on the average per year. That’s a pretty reasonable system. Now, if you risked 1% per trade, then you’d probably make 75% per year trading that system…maybe even 100% with compounding.
However, let’s say that you make one mistake each week. And let’s say that every mistake you make costs you 2R. That means that over the course of a year you’ve cost yourself 104R in mistakes. And your system produces an average profit of 75R per year. That means that the net result is a loss of 29R. I’d say that probably describes what happens with most traders that have a reasonable system.
They continue to make mistakes and don’t learn from them.
StockTickr: How do you think the stock market has changed over the last several years? How do you recommend traders adapt to longer term market shifts?
Van: I think we’re in a secular bear market that will last another 15 years. This doesn’t say anything about what the stock market will do in say 2006. It really doesn’t even predict prices. Rather a secular bear market means that I expect PE ratios to decline over the next 15 years. Secular bear markets usually end with single digit PE ratios.
Now since 2000, when this started, we’ve only had one good up year, 2003. In 2003, the S&P 500 finished up 25%. However, during 2003 the dollar lost 40% versus the Euro and almost every stock market in the world outperformed the U.S. stock market. That, I think, describes what typically happens in a secular bear market.
I think crisis means opportunity. You can go short the market when it goes in prolonged down periods. And there’s lots of opportunity because there are now ETFs that represent most aspects of the market, including most foreign stock markets. So there’s lots of opportunity. However, the most dangerous place to be, in my opinion, is in a lot of mutual funds. My guess is that 75% of them will be out of business by the time the secular bear market is over.
StockTickr: What is the most common, but easily corrected fault you see in traders?
Van: There are many but I’ll give you one that is the root of everything else. Make the assumption that you totally create your investment results. That way, if you are not meeting your objectives, you will look to yourself as the source of the problem and not something outside of yourself …like the market or your broker.
StockTickr: What advice do you give investors who are just starting out?
Van: Probably the advice I just gave is perfect for the beginner. Know that you are responsible for the results that you create in the markets.
And, the markets will give you plenty of lessons about yourself – so be willing to learn about yourself and then you can fix your mistakes.
StockTickr: In addition to your own, which 2-3 books do you recommend traders read?
Van: My three:
Market Wizards : Interviews with Top Traders (Jack Schwager)
The New Market Wizards (Jack Schwager)
Unexpected Returns: Understanding Secular Stock Market Cycles by Ed Easterling
StockTickr: What mistakes do you see commonly made in backtesting?
Van: For many people doing backtesting might be a mistake. People do backtesting because they think that computers can tell them if their system works. However:
1) I guess that almost all the software you’ll use has a 10% error rate in the outcome.
2) Data that you might use is frequently flawed.
3) People cannot test the same way they’d trade, with multiple positions on making decisions time frame by time frame. Thus, most backtesting is not realistic of how you’d trade.
4) If 1-3 were perfect, what would happen is that you’d get a set of R-multiples. However, that’s just a sample of what you can expect. What happens when it comes in a different order? What happens if you haven’t seen your biggest R loser? What happens if your sample does not accurately represent what really happens with your system?
What we teach is that you can only trade a system that you are comfortable with. This means:
1) Knowing yourself
2) Knowing your objectives
3) Knowing your beliefs about the market and each aspect of your system.
4) Understanding how it all works. Tom Basso used to say the more you understood how your system works, the less testing is necessary. How will your system perform in all kinds of market conditions?
5) And what criteria do you need beside those I’ve just mentioned to feel comfortable trading your system? Perhaps backtesting is one, but if so, then realize all the limitations I’ve just mentioned. You could also trade your system with very small position size and generate a realistic set of R-multiples. That might be a better way to test it.
StockTickr: What do you like best about stock trading?
Van: I guess trading teaches me about myself. Thus, I’m one of those who can use trading as a benchmark of my personal growth and evolution.
StockTickr: Thanks, Van!
Sign up for StockTickr Pro to receive an autographed copy of one of Van’s books while supplies last.
Stay tuned – there are several interviews on the way. You can subscribe to these interviews via RSS feed.
- Brett Steenbarger
- Eyal Maoz
- Gary B. Smith, the Chartman
- Nusair Bawla (alibawla on StockTickr)
- Dave Landry, Swing Trader
- Jeff White, the Stock Bandit
Do you have suggestions for other traders you’d like to see an interview with? Let us know!