Trade Your Way to Financial Freedom

181 Pages·2006·2.916 MB·English

by  Van K Tharp

TRADE YOUR WAY
TO FINANCIAL FREEDOM
Foreword by David Mob& Sr. xiii
Acknowledgements xvii
VAN K. THARP
Preface xxi
PART ONE
THE MOST IMPORTANT FACTOR
IN YOUR SUCCESS: YOU!
The Legend of the Holy Grail 3
The Holy Grail Metaphor 6
What’s Really Important to Trading 9
Modeling Market Geniuses 11
Summary 14
chapter 2
Judgmental Biases: Why Mastering the Markets Is So Difficult
for Most People 17
Biases That Affect Trading System Development 20
Biases That Affect How You Test Trading Systems 35
Biases That Affect How You Trade Your System 38
Summary 41
Chapter 3
__-
Setting Your Objectives 45
Designing Objectives Is a Major Part of Your System Work 47
Tom Basso on Objectives 48 Chapter 6
Setting Your Own Objectives 57 Understanding Expectancy and Other Keys
to Trading Success 130
The Six Keys to Investment Success 130
PART TWO:
The Snow Fight Metaphor 133
CONCEPTUALIZATION OF YOUR SYSTEM
Looking at Expectancy under a Magnifying Glass 137
Expectancy and R Multiples 143
Chapter 4
Expectancy Applied to the Market 148
Steps to Developing a System 61 Using Expectancy to Evaluate Different Systems 152
1. Take an Inventory 61 A Review of How to Use Expectancy 158
2. Develop an Open Mind and Gather Market Information 63
3. Determine Your Objectives 66
4. Determine Your Time Frame for Trading 66
PART THREE:
5. Determine the Best Historical Moves in That Time Frame and
Notice What Those Moves Have in Common 69
UNDERSTANDING THE KEY PARTS
6. What’s the Concept behind Those Moves and How Can You OF YOUR SYSTEM
Objectively Measure Your Concept? 70
7. Add Your Stops and Transaction Costs 72
Chapter 7
8. Add Your Profit-Exits and Determine Your Expectancy 73 __-
9. Look for Huge Reward Trades 74 Using Setups 165
10. Optimize with Position Sizing 76 The Four Phases of Entry 167
11. Determine How You Can Improve Your System 77 Setups for Stalking the Market 172
12. Worst-Case Scenari-Mental Planning 78 Filters versus Setups 179
Setups Used by Well-Known Systems 184
Chapter 5
hnmary of Setups 196
Selecting a Concept That Works 81
Trend Following 82 Chapter 8
Fundamental Analysis 86
Entry or Market Timing 198
Seasonal Tendencies 91
Trying to Beat Random Entry 200
Spreading 99
Common Entry Techniques 202
Arbitrage 103
Designing Your Own Entry Signal 220
Neural Networks 110
There’s am Order to the Universe 120 An Evaluation of Entry Used in Some Common Systems 224
Sunmary 229
Summary of Key Points 126
Chapter 9 chapter 13
Know When to Fold ‘Em: How to Protect Your Capital 233 Conclusion! 314
What Your Stop Does 235
Using a Stop That Makes Sense 243 APPENDICES
Summary: Preserving Capital 248
Appendix I: Recommended Readings 325
Stops Used by Common Systems 249
Appendix II: Key Words Defined 328
Chapter 10
How to Take Profits 254
Index 337
Purpose behind Profit-Taking Exits 255
Just Using Your Stop and a Profit Objective 263
Simplicity and Multiple Exits 264
What to Avoid 265
Summary 266
Exits Used by Common Systems 266
Chauter 11
The Opportunity and Cost Factors 270
Several Approaches to Take 270
Factoring in Opportunity 273
The Cost of Trading Opportunity 275
Summary 278
Chapter 12
What Do You Mean Position Sizing? I Only Have $10,000
in My Account! 280
Position-Sizing Strategies 284
Model 1: One Unit per Fixed Amount of Money 286
Model 2: Equal Value Units for Stock Traders 290
Model 3: The Percent Risk Model 292
Model 4: The Percent Volatility Model 296
The Models Summarized 298
Examples of the Impact of Position Sizing 300
Summary 306
Position Sizing Used by Other Systems 307
F O R E W O R D
The title of Chapter 1 of this book is: “The Legend of the Holy
Grail.” “The Holy Grail” is a phrase you often hear in some trading
and investment circles. Most people believe that it refers to some
mysterious trading system out there that is going to make them
millions with little or no risk. It’s not that at all.
But before I tell you about the Holy Grail, let me tell you a lit-
tle about who I am and why Dr. Tharp asked me to write the
Foreword to his book. I started managing other peoples’ money in
1992 and in just 5 years those assets have grown from about $3 mil-
lion to about $50 million. That has happened partially because my
hedge fund has compounded by better than 40 percent per year, net
to investors, over the last 5 years. We were up 61 percent net to
investors in 1996 and 53 percent net to investors in 1997. Since I met
Dr. Tharp, my net worth has grown many times over, and I do
believe that it comes from adopting many of the Holy Grail secrets
contained in this book. I think that Dr. Tharp understands and
teaches those,secrets better than anyone else I have ever met. Let
me tell you why:
When I was a young boy, I remember dreaming that I would
become a millionaire by the time I reached 25 years of age. I reached
that goal through real estate development in 1981, but only briefly
and then it all came tumbling down around me. I was devastated,
but I picked myself up and started again. My next attempt at real
success was in the investment field.
Yet I almost had a similar type of crash in my fortunes. I
remember the day clearly. I was sitting in my office in Naples,
Florida, in late 1992. It was a typical south Florida autumn day. I
was watching the palm trees sway in the breeze outside my win-
dow, wondering why my trading had become more difficult since
I began managing money for others. I wasn’t about to crash at the
xiii
time, but I had the same sort of feeling in my gut that I had had I must admit that when I first learned what Dr. Tharp was
before my first crash. going to write about in this book, I was concerned. He was giving
My interests in investing began in 1967, when I would make away too many of our secrets! However, I’m not concerned any
regular trips to the local public library to devour every book I could more because I now realize that those secrets are so personal. My
find on investing. I’d also study biographies of successful busi- Holy Grail is not the same as your Holy Grail. In addition, many of
nesspeople. I certainly wish I had been aware of Dr. Tharp’s mod- you will just let those secrets pass by you, so I urge you to be care-
eling work back then, because it would have saved me so much ful. Read this book carefully. Indeed, pay particular attention to:
time and so many heartaches.
. Understanding the psychological biases against good
In 1969, at the age of 13, I talked my reluctant parents into
system development (Chapter 2)
opening a brokerage account for me at the local Merrill Lynch office
. Setting objectives for what you are trying to accomplish
in Toledo, Ohio. The conditions of the account: I had to fund the
(Chapter 3)
account myself from lawn mowing and odd jobs, and every trade
. Understanding expectancy and R multiples
had to be confirmed by my mother since it was a Unified Gift to
(Chapters 6 through 10)
Minors Act account. Once open, my father would occasionally give
me a little money to put into the account, as long as I didn’t tell my . Realizing that the golden rule of trading is created by how
mom. you get out of the markets, not by picking some magic
As I looked out the window, I realized how fortunate I was. I stock (Chapters 9 and 10)
now lived in a tropical climate. I had probably again achieved my . Understanding the importance of position sizing
childhood dream of success doing something I loved to do. (Chapter 12)
Twenty-two years had gone by since I made my first trade; only
And pay special attention to the meaning of the Holy Grail as
now I was doing it successfully. Yet, somehow, I was now begin-
described in Chapter 1. Until you’ve mastered yourself, you’ll
ning to find trading difficult.
always struggle with the market. I wish all of you could integrate
That nervous feeling helped me open up to whole new levels
that meaning into your being and then truly apply it to your trading.
of success-way beyond those of my first childhood dreams. That
The material that Dr. Tharp presents in this book, in his Market
feeling was the key to what was going on, and the key to my suc-
Mastery newsletter, in his home-study courses, and in his seminars
cess, but I didn’t know what that key was- not yet at least.
will change your life if you are open to them. I urge you to take the
A few days later, I notice a magazine ad about Dr. Van Tharp.
first step today and open yourself up to the material found in this
I had read about him in Jack Schwager’s book Market Wizards, so I
book. Enjoy the journey It’s a great one!
decided to give him a call. That call was the start of a close profes-
sional and personal relationship that would end up affecting my
life, my family, and even my business interests and associates. I
David Mobley, Sr.
already understood many of the secrets contained in this book.
Naples, Florida
However, through my association with Dr. Tharp, I now under-
February 2998
stood the ultimate aspect of the Holy Grail secret-the part that Dr.
Tharp so eloquently describes in Chapter 1.
The Holy Grail is not what you would expect it to be. It is
something that is different for each person. It’s a hidden secret that
you have to discover for ydurself, but it is obvious ~once it is real-
ized.
ACKNOWLEDGMENTS
This book is a product of 15 years of thinking about markets, study-
ing hundreds of great traders and investors, and coaching many
more to greatness by helping them apply some of the principles
you’ll find in this book. If this book helps hundreds more, even if I
never meet you, it will have been worth the effort.
During those 15 years, numerous people have helped shape
the thinking that has gone into this book. I can only acknowledge a
few of those people by name. However, everyone who contributed
in any way has my deepest thanks and appreciation.
I’d like to acknowledge Ed Seykota for showing me very early
on the importance of simplicity and creative money management.
Ed has presented at three of my early seminars, and I’m deeply
indebted to his wisdom.
Tom Basso has been a great contributor to my thinking and my
life. Tom was a guest speaker at more than a dozen of my seminars
and several of our professional trader schools. Tom has also con-
tributed several sections to this book. Thank you, Tom.
Ray Kelly was one of my earliest clients. I’ve watched him
evolve from a tough floor trader-whose favorite saying used to be
“My way or the highway!“-into someone who would freely give
his time to inner-city high school kids just to convince them to start
to take responsibility for their lives. Ray is one of the best traders I
know and a great teacher as well. He’s presented at many of my
seminars and has written the arbitrage section of this book.
Chuck LeBeau helped me make the link from the famous
trader’s axiom-“Cut your losses short and let your profits run”-
to the importance of exits. Think about it. Cutting losses short is all
about aborting losses--exits. Letting profits run is all about exits
as well. The entire axiom is all about exits. Chuck’s persistence in
driving home this point has been very valuable to me. Chuck is
xvii
xviii Ac!aomledgments xix
now a guest speaker at my advanced systems seminar and has also project started, but now that I can actually see the results of using
contributed a section to this book on fundamental analysis. the software I know that its importance is beyond anything that I
I would also like to acknowledge a very special person in my had imagined.
life--David Mobley, Sr. I’ve probably done more consulting with I’d like to thank everyone in my supertrader program. Several
David than any other trader. I’ve also worked with most of his fam- of them-William Curtiss and Rolf Sigrist-who continually
ily. I’ve watched them all grow tremendously over the last 6 years bounce their great, creative ideas off me, have helped shape my
since we’ve been close, but especially David. Thus, it is with great thinking tremendously through their education process. I’d also
pleasure that I asked David to write the Foreword to this book. like to thank Loyd Massey and Frank Gallucci for their tremendous
David’s company, Maricopa, was one of our first graduating com- suggestions in reviewing the manuscript. I’d also like to thank
panies. Bruce Feingold, Sir Mark Thomson, Dennis Ullom, Willard
Kevin Thomas, Jerry Toepke, and Louis Mendelsohn all con- (“Buddy”) Harper, Andreas Pfister, Corky Dobbs, and Jim
tributed great sections to the concepts chapter (Chapter 5). Their Hetherington for the tremendous insights I’ve gained from work-
work is very insightful and helpful I deeply appreciate your con- ing with them.
tributions. Some very special teachers in my life deserve a special men-
I’d also like to acknowledge our first graduates-Webster tion. These include Connierae Andreas, Deepak Chopra, Robert
Management. Three key people at Webster met at my school for Dilts, Todd Epstein, John Grinder, Tad James, Robert Kivosaki,
professional traders. They have achieved tremendous success by John Overdurf, James Sloman, Enid Vien, and Wyatt Woo&mall.
understanding the key components necessary for investment and Your contribution to my personal evolution has been tremendous.
trading success+xpectancy and money management. I’d particu- I’d like to thank my editors at McGraw-Hill for their wonder-
larly like to acknowledge the contributions to my thinking from ful help. Stephen Isaacs miraculously appeared when I needed a
Paul Emery, Rob Friedl, Parker Sroufe, and Paul Rusnock. publisher and John Morriss was very helpful throughout the pro-
Chuck Branscomb has been a great model for me of how to duction process.
adopt these principles. When he first came to my seminars, he Lastly, but not least, I’d like to thank my staff at I.I.T.M., Inc.
thought he had a great system-when he really had no system at for their support in completing this book. Cathy Hasty has been a
all, just some entry signals. He’s attended all my system seminars great help in laying out the book and with the graphics. Annette
(except for one held in London) and most of the other seminars. French has always “been there” to assist me with whatever was
I’ve watched him evolve into a very knowledgeable systems trader. necessary.
He’s also a great example of how solid “intuition” about the mar- My deepest thanks go to all of you and to the many people
ket evolves out of solid systems trading. Chuck is the editor of our who also contributed, but were too numerous to mention.
newsletter, Market Mastery, and several excerpts from Chuck’s
work were put into this book. In addition, Chuck helped tremen-
dously in generating some of the graphics in this book.
John Humphreys is the senior developer of Athena Money
Management software used in this book. John has incorporated all
my suggestions about money management into the software to the
point where one can now begin to see the millions of possibilities
that exist in money management, which I call “position sizing”
throughout this book. I knew position sizing was critical when the
P R E F A C E
A number of my clients have asked me not to include certain sec-
tions in this book, with the admonishment of “You’re giving away
too much.” Yet my job is to coach traders and investors to achieve
peak performance. Every available tool is important in attempting
to do that, because so much misinformation is available in the lit-
erature that the average person will constantly be led astray
Most of the misinformation is not deliberate. People want to
be led astray. They constantly ask the wrong questions, and those
selling information get rewarded by giving them the answers they
want. For example:
. What’s the market going to do now?
. What should I buy now?
. I own XYZ stock. Do you think it’s going to go up? (If you
say no, then they’ll ask someone else until they find a
person who agrees with their opinion.)
. Tell me how I can get into the market and be “right” most
of the time.
In April 1997, I did a Z-day seminar in Germany. Toward the end of
the seminar, I gave the participants the choice of doing an exercise
dealing with self-sabotage (which all of them needed) or asking me
questions. They took a vote on what to do. Guess what the first
question asked of me was? “Dr. Tharp, what’s your opinion about
what the U.S. stock market will do for the rest of 1997?” This was
despite my best efforts over the past two days to explain to them
why such questions were unimportant.
When people move beyond questions of “what” to buy into
questions about “how,” they still ask the wrong questions. Now the
question becomes something like:
What criteria should I use to enter the market in order to be right
most of the time?
ui
xxii Preface Preface xxiii
There is a large industry available to give you the answer to such the software would be wonderful. However, the reality is that you
questions. Hot investment books are filled with entry strategies cannot predict prices in this manner. But it does sell a lot of soft-
that the authors claim to be 80 percent reliable or to have the ware.
promise of big gains. A picture tends to be worth a thousand words, I have over 15 years of experience as a coach for traders. I
so each strategy is accompanied by a graph in which the market have worked with some of the top traders and investors in the
just took off. Such “best-case” pictures can sway a lot of people and world and have completed thousands of psychological evalua-
sell a lot of books. tions on all sorts of traders and investors. As a result of my back-
At an investment conference in 1995, a well-known speaker on ground and experience, I have filled this book with the kind of
the futures markets talked about his high-probability entry signals. information that will help you really improve your performance as
The room was packed as he carefully explained what to do. Toward a trader or investor.
the end of the talk, one person raised his hand and asked, “How do During that research period, many of my own beliefs about
you exit the market?” His response, albeit facetiously, was, “You the market have been shattered. I expect many of your most
want to know all my secrets, don’t you?” “sacred” beliefs about trading or the market (or perhaps even your
At another conference about a year later, the keynote speaker beliefs about yourself) will be shattered before you finish this book.
gave an hour talk before 600 people on high-probability entry tech- The reason is that you can learn the real “secrets” to the market
niques. Everyone listened eagerly at every word. Nothing was said only if you pay attention to what really works. If your attention is
about exits except that one should keep a tight stop and pay close elsewhere, you are not likely to find any secrets. However, this
attention to money management. After the talk, this particular book simply contains my beliefs and opinions. Explore its contents
speaker sold $10,000 worth of books in about a half-hour period, with an open mind and you will take a giant leap forward in your
because people were so excited that such high-probability entry ability to make money consistently.
techniques were the answer. I have divided this book into three primary parts: Part One is
At the same conference, another speaker talked about money about self-discovery and moving yourself to a point where it’s pos-
management-the key factor in determining one’s profits. Thirty sible for you to do market research. I’ve included a chapter on the
people listened to the talk, and about four of them purchased a essence of successful trading, a chapter on judgmental heuristics,
book having to do with that particular topic. and a chapter on setting your personal objectives in this section.
People gravitate toward the things that don’t work. It’s I’ve deliberately made this a short section, so you won’t get too
human nature. You’ll learn why this occurs and what to do about it impatient with me for not giving you what you probably think is
in this book. the “meat” of the topic of system development. However, this
Such stories could be told about conference after conference. material is critical to your success!
Everyone will flock to a talk on high-probability entry signals, and Part Two deals with my model for system development. It
less than 1 percent will learn anything significant. However, talks covers concepts behind trading or market systems, and I’ve invited
featuring the most important keys to making real money will have various experts to write the sections behind those concepts. Part
few people in attendance. 'ho also deals with expectancy-ne of the key ideas that every-
Even the software products dealing with the markets have one should understand. Few people who are actively involved in
the same biases built into them. These products typically are the markets even know what expectancy means. Even fewer peo-
loaded with indicators that can help you perfectly understand ple understand the implications of designing a system around
why markets did what they did in the past. Why wouldn’t they? expectancy. Thus, you may find it important to study this section
Those indicators are formed from the same past data about which carefully.
they are predicting prices. If you could do that with future prices, Part Three involves the various parts of a system. These
Reface PART ONE
xxiv
The Most Important
include setups, entry or timing techniques, stop-loss exits, profit- Factor in Your Success:
taking exits, and one of the most critical chapters in the book, posi-
tion sizing. I’ve also included a concluding chapter on all the other YOU!
important topics that had not yet been addressed.
Vats K. Thnrp, Ph.D.
fune 1998
The objectives of this book are twofold:
1. To help you in your search for the secrets of the “Holy
Grail”
And at the same time,
2. To help you in your search for a winning trading system
that’s right for you
There is a critical assumption in both of those objectives: that you
are the most important factor in your performance. Jack Schwager,
after writing two books in which he interviewed some of the
world’s top traders, concluded that the most important factor in
their success was that they each had a trading system that was right
for them. I’d like to take that assumption one step further: You can-
not design a system that is right for you unless you know some-
thing about yourself.
As a result, the first part of this book is about self-discovery
and moving yourself to a point where it’s possible for you to do
market research. I’ve included a chapter on the psychological
essence of successful trading, what the Holy Grail is really all
about; a chapter on judgmental heuristics; and a chapter on setting
Your personal objectives.