We have only to follow the hero’s path, and where we had thought to find an abomination, we shall find a god. And where we had thought to slay another, we shall slay ourselves. Where we had thought to travel outward, we will come to the center of our own existence. And where we had thought to be done, we will be with all the world.
Joseph Campbell,
The Power of Myth(page 51)
Let me tell you a secret about the market. You can make big money buy buying breakout that go beyond a normal day’s range of price movement. These are called volatility breakouts. One trader is famous for making millions with volatility breakouts. You can do it too! You can make a bundle! Here’s how you do it.
First, you take yesterday’s price range. If there’s a gap between yesterday and the day before, then add the gap into the range. That’s called the true range. Now, take 40 percent of yesterday’s true range, and bracket today’s opening price by that amount. The upper value is your buy signal, and the lower value is your sell signal (that is, for selling short). If either value is hit, get into the market, and you’ll have an 80 percent chance of making money. And over the long run, you’ll make big money.
Did that particular pitch sound interesting to you? Well, it has attracted thousands of speculators and investors alike. And while there’s some truth to the pitch – it can be a basis for making big money in the market – it’s certainly not magic secret to success. Many people could go broke following that advice because it’s only part of a sound methodology. For example, it does not tell you
- How to protect your capital if the market goes against you
- How or when to take your profits
- How much to buy or sell when you get a signal
- What markets the method is designed for and it it works in all markets
- When the method words and when it fails miserably
Most importantly, you must ask yourself, when you put all of those pieces together, does the method fit you? Is it something you’d be able to trade? Does it fit your investment objectives? Does it fit your personality? Can you tolerate the drawdowns or the losing streaks it might generate? Does the system meet your criteria for feeling comfortable trading it, and what are those criteria?
This book is intended to help traders and investors make more money by learning more about themselves and then designing a methodology to fit their own personality and objectives. It is intended for both traders and investors because both of them attempt to make money in the markets. The trader tends to have a more neutral approach – being willing to both buy and sell short. The investor, in contrast, is looking for an investment that can be purchased and held over a longer period of time. Both of them are looking for a magic system to guide their decision making – the so-called Holy Grail system.
The journey into finding the profits available in the markets usually starts another way. In fact, the typical investor or trader, in preparing to trade, goes through an evolutionary process. At first he gets hooked on the idea of making a lot of money. Perhaps some broker gives him a pitch about how much money he can make playing the market. I’ve heard a radio advertisement in North Carolina that goes something like this:
Do you know where real money is made year after year? It’s all in the agricultural sector – people have to eat. And when you consider the weather we’ve been having lately, there’s likely to be a shortage. And that means higher prices. And for just a small investment of $5,000, you can control a lot of grain. You’ll make a small fortune if grain moves just a few pennies in your favor. Of course, there are risks in this sort of recommendation. People can and do lose money. But if I’m right about what I’m saying, just think how much money you can make.
(I’ve heard similar pitches for various other commodities and, these days, even for currency trading.)
Once the trader has committed his initial $5,000, he’s hooked. Even if he loses it all – and in most cases he will – he’ll still retain the belief that he can make a big money playing the markets. “Didn’t Hillary Clinton turn $1,000 into $100,000? If she can do it, then I certainly can do it.” As a result, our investor will spend a great deal of time trying to find someone to tell him what to buy and sell in his quest to determine the hot prospect.
I don’t know many people who have made money consistently following other people’s advice There are exceptions, but they are very rare. In time, the people who have followed other people’s advice are have consistently lost their capital get discouraged and drop out of picture.
Another pitch that really seems to get people is the newsletter pitch. That typically goes something like this: “If you had followed our guru’s advice, you would have make 320 percent on XYZ, 220 percent on GEF, and 93 percent on DEC. And it’s not too late. You can get our guru’s picks for each of the next 12 months for only $1,000.” As you’ll learn from both the expectancy chapter and the position sizing chapter, one could easily have gone broke following such a guru’s advice because we know noting about his or her downside or even the expectancy of his or her system.
I once heard this pitch from an options trading guru: “If you had followed my advice on every trade last year, you would have turned $10,000 into $40,000.” Now does that sound impressive? It does to most people, but what he really meant was if you had risked $10,000 on every trade recommendation made, then at the end of the year, you would have been up by $40,000. In other words, if your risk per trade was 1R (where R is the short for risk), then you would have been up by 4R at the end of the year. Believe me when I say that 99 percent of the trading systems you’ll probably develop will give you better performance than this one. Nevertheless, people fork out the $1,000 for the guru’s advice because the pitch suggests a 400 percent return rather than a 4R return. That is, they do until they decide that perhaps they should ask a better question.
A few people miraculously move onto the nest phase, which is “Tell me how to do it.” Suddenly, they go on a wild search for the magic methodology that will make them a lot of money. This is what some people call the “search for the Holy Grail.” During the search, our trader is looking for anything that will provide her with the secrets to unlocking the universe of untold riches. Typically, people in this phase go to lots of seminars in which they learn about various methods such as this one:
Now this is my chair pattern. It consists of at least six bars in a congestion range followed by a seventh bar that seems to break out of the congestion. Notice how it looks like a chair facing to the left? See what happens on this chart after the chair pattern occurred – the market just zoomed up. And here’s another example. It’s that easy. And here’s a chart showing how much profit I made with the chair pattern over the last 10 years. Look at that: $92,000 profit each year from just a $10,000 investment.
Somehow, when these investors actually try to use the chair system, that $10,000 investment turns into large losses. (You’ll learn the reasons for these losses later in this book). Such setbacks notwithstanding, these investors simply go looking for yet another system. And they continue in this losing cycle until they are finally broke or they learn the real meaning behind the Holy Grail metaphor.
The Holy Grail Metaphor
In trading circles, one frequently hears: “She’s searching for the Holy Grail.” Typically this means that she’s searching for the magic secrets of the market that will make her rich – the secret rules that underlie all markets. But are there such secrets? Yes, there are! And when you really understand the Holy Grail metaphor, you will understand the secrets of making money in the market.
Several books such as Malcolm Goodwin’s Holy Grail deal with the topic of the Holy Grail metaphor. Beyond the Grail romances themselves, the metaphor has been used extensively throughout history, and most Westerners instantly recognize something described as a “Grail quest” as very significant. Scholars have used the term to mean all types of things, from blood feuds to searches for everlasting youth. Some scholars consider a “Grail quest” to be a search for perfectionism, enlightenment, unity, or even direct communion with God. The investor’s “search for the Holy Grail” has been framed within the context of those other quests.
Most investors believe that there is some magic order to the markets. They believe that a few people know about it and that those few are making vast fortunes from the market. These believers are constantly trying to discover the secrets so that they too can become wealthy. Such secrets exist. But few people know where to find them because they are where one would least expect the secrets to be.
As you complete more and more of this book, you’ll really understand the secrets of making money in the markets. And as those secrets are revealed to you, you’ll begin to understand the real meaning of a “Grail quest.”
According to one interesting Grail account, there is an ongoing war in heaven between God and Satan. The Grail has been placed in the middle of the conflict by neutral angels. Thus, it exits in the midst of a spiritual path between pairs of opposites (such as profits and losses.) Over time this territory of concern has become a waste-land. Joseph Campbell says that the wasteland symbolizes the inauthentic life that most of us lead. Most of us typically do what other people do, following the crowd and doing as we’re told. Thus, the wasteland represents our lack of courage to lead our own life. Finding the Holy Grail represents finding the means to escape the wasteland – which means leading our own life and thereby attaining the ultimate potential of the human psyche.
Investors who follow the crowd might make money during long trends, but overall they’ll probably lose, while the investors who are thinking and acting independently will usually make money. What’s holding back the crowd followers? They ask others for advice (including their neighbors) rather than thinking independently and designing a method that fits them. Most investors have a strong desire to be right about every trade, and so they find some hot entry technique that gives them a feeling of control over the market. For example, you can require that the market totally do your bidding before you enter it. Yet real money is made through intelligent exits because they allow the trader to cut losses short and let profits run. Making intelligent exits requires that the trader be totally in tune with what the market is doing. In summary, people make money in the markets by finding themselves, achieving their potential, and getting in tune with the market.
There are probably hundreds of thousands of trading systems that work. But most people, when given such a system, will not follow it. Why not? Because the system doesn’t fit them. One of the secrets of successful trading is finding a trading system that fits you. In fact, Jack Schwager, after interviewing enough “market wizards” to write two books, concluded that the most important characteristic of all good traders was that they had found a system or methodology that was right for them. So part of the secret of the Holy Grail quest is in following your own unique way – and thus finding something that really fits you. But there is still a lot more to the Holy Grail metaphor.
People make money in the markets by finding themselves, achieving their potential, and getting in tune with the market.
Life starts out in the neutral position between profits and losses – it neither fears losses nor desires profits. Life just is, and that’s represented by the Grail. However, as a human being develops self-awareness, fear and greed also arise. But when you get rid of the greed (and the fear that comes from lacking), you reach a special unity with everything. And that’s where great traders and investors emerge.
Joseph Campbell, the late, great scholar and leading expert on myths, says:
Suppose the grass were to say, “Well, for Pete’s sake, what’s the use if you keep getting cut down this way?” Instead, it keeps on growing. That’s the sense of the energy at the center. That’s the meaning of the image of the Grail, of the inexhaustible fountain of the source. The source doesn’t care what happens once it gives into being.
One of the Grail legends starts out with a short poem that states: “Every act has both good and evil results.” Thus every act in life has both positive and negative consequences – profits and losses, so to speak. The best we can do is to accept both while leaning toward the light.
Think about what that means for you as an investor or trader. You’re playing a game of life. Sometimes you win and sometimes you lose, so there are both positive and the negative, you need to find that special place inside of you in which you can just be. From that vantage point, wins and losses are equally a part of trading. That metaphor, to me, is the real secret of the Holy Grail.
To accept both the positive and the negative, you need to find that special place inside of you in which you can just be. From that vantage point, wins and losses are equally a part of trading.
If you haven’t found that place in yourself, then it’s very hard to accept losses. And if you cannot accept the negative consequences, you’ll never succeed as a trader. Good traders usually make money on less than half their trades. If you can’t accept losses, then you are not likely to want to get out of a position when you know you are wrong. Small losses are more likely to turn into giant ones. More importantly, if you cannot accept that losses will occur, then you cannot accept a good trading system that will make a lot of money in the long run but might lose money 60 percent of the time.
What’s Really Important To Trading
Almost every successful investor that I have encountered has realized the lesson of the Holy Grail metaphor – that success in the markets comes from internal control. This is a radical change for most investors. Internal control is not that difficult to achieve, but it is difficult for most people to realize how important it is. For example, most investors believe that markets are living entities that create victims. If you believe that statement, then it is true for you. But markets do not create victims; investors turn themselves into victims. Each trader controls his or her own destiny. No trader will find success without understanding this important principle at least subconsciously.
Let’s look at some facts:
- Most successful market professionals achieve success by controlling risk. Controlling risk goes against our natural tendencies. Risk control requires tremendous internal control.
- Most successful speculators have success rates of 35 to 50 percent. They are not successful because they predict prices well. They are successful because the size of their profitable trades far exceeds the size of their losses. This requires tremendous internal control.
- Most successful conservative investors are contrarians. They do what everyone else is afraid to do. They buy when everyone else is afraid, and they sell when everyone else is greedy. They have patience and are willing to wait for the right opportunity. This also requires internal control.
Investment success requires internal control more than any other factor. This is the first step toward trading success. People who dedicate themselves toward developing that control are the ones that will ultimately succeed.
Let’s explore internal control, the key to trading success, from another perspective. When I’ve had discussions about what’s important to trading, three areas typically come up: psychology, money management (that is, position sizing), and system development. Most people emphasize system development and deemphasize the other two topics. More sophisticated people suggest that all three aspects are important but that psychology is the most important (about 60 percent), position sizing is the next most important (about 30 percent), and system development is the least important (about 10 percent). These people would argue that internal control would fall only into the psychological sector.
A good trader once told me that his personal psychology did not enter into his trading at all because everything he did was automated. I responded, “That’s interesting, but what if you decide not to take one of your signals?” He responded, “That would never happen!” About six years later this trader went out of business as a professional trader because his partner did not take a trade. That trade would have made them very profitable for the year because it was a huge winner, but they’d had so many losses in that particular area that his partner decided not to take it.
A great trader once told me that he taught a college course in trading (in the later 1970s) that lasted 10 weeks. He spent the first week of class teaching basic information about trading. He then spent another week teaching the class Donchian’s 10-20 moving average crossover system. However, he needed the remaining eight weeks of the class to convince people to use the system that he had taught – to get them to work on themselves enough to accept the losses that it (or any other good trading system) would generate.
I’ve argued for a long time that trading is 100 percent psychology and that psychology includes position sizing and system development. The reason is simple: We are human beings, not robots. To perform any behavior, we must process information through the brain. Behavior is required to both design and to execute a trading system. And to duplicate any behavior, one must learn the ingredients of that behavior. That is where the science of modeling comes into play.
Modeling Market Geniuses
Perhaps you have had the experience of attending a workshop conduced by an investment expert who explains his success secrets. For example, I just told you about a class that one of the world’s greatest traders taught on trading in the early 1970s. He spent the first two weeks teaching the class a method that would have made them very rich (at the time) and then the following eight weeks getting the class to the point where they were willing to apply it.
Like the people in the class, you may have been impressed in some workshop you attended by the expert’s presence and skills. You may have left the workshop full of confidence that you could make money using his methods. Unfortunately, when you tried to put his secrets into practice, you may have discovered that you weren’t much wiser than you were before the workshop. Something didn’t work, or somehow you just couldn’t apply what you had learned.
Why does this occur? The reason is that you do not structure your thinking in the same manner as the expert. His mental structure, the way he thinks, is one of the keys to his success.
When others teach you how they approach the markets, chances are they only superficially teach you what they actually do. It’s not that they mean to deceive you. It’s just that they really do not understand the essential elements of what they do. And even if they did, they would probably have trouble transferring that information to someone else. This leads people to assume that perhaps you must have a certain “gift” or type of talent to be successful in the markets. Many people, as a result, become discouraged and leave the markets because they believe that they do not have the talent. But talent can be taught!
I believe that if at least two people can do something well, then the skill can be taught to most other people. The key to teaching the skill is to model it first. Over the last 20 years, the science of modeling has emerged almost as an underground movement. The movement comes out of a technology developed by Richard Bandler and John Grinder called neuro-linguistic programming (NLP, for short).
If at least two people can do something well, then the skill can be taught to most other people.
NLP seminars usually just cover the trail of techniques left behind by the modeling process. For example, when I give a seminar, I usually just teach the models I’ve developed from modeling top traders and investors. However, if you take enough NLP classes, you eventually begin to understand the modeling process itself.
I’ve modeled three primary aspects of trading pus the process of developing wealth. The first model I developed is on how to be a great trader-investor and master of the markets. Essentially, the steps to developing such a model involve working with a number of great traders and investors to determine what they do in common. If you attempt to model one person, you will find a lot of idiosyncrasies that are unique to that person. But if you model the common elements of a number of good traders and investors, then you find what’s really important to the success of all of them.
For example, when I first asked my model traders what they did, they told me their methodology. After interviewing about 50 traders, I discovered that none of them had the same methodology. As a result, I concluded that their methods were not a secret to their success except that their methods all involved “low-risk” ideas. Thus, one of the ingredients that all these traders had was the ability to find low-risk ideas. I’ll define a low-risk idea later in the next chapter.
Once you discover the common elements to what they do, then you must discover the real ingredients of each common task. What are the beliefs that enable them to master the markets? How do they think so that they can effectively carry out those tasks? What are the mental strategies necessary to do the task (that is, the sequence of their thinking)? What are the mental states necessary to perform the task (for example, commitment, openness)? These ingredients are all psychological, which is another reason that I believe trading (or anything else for that matter) is 100 percent psychological.
The last step in determining if you’ve successfully developed an accurate model is to teach the model to others and determine if they get the same results. The trading model I’ve developed is part of my Peak Performance Home Study Course. We also teach the model in our Peak Performance Workshop. And we’ve been able to create some amazingly successful traders, thus verifying the model.
The second model I developed is on how great traders and investors learn their craft and how they do their research. That’s the topic of this bool. Most people consider this to be the nonpsycho-logical part of trading. The surprise is that the task of finding and developing a system that is right for them is purely a mental one. You must discover your beliefs about the market so that your system will fit those beliefs. You must know yourself well enough to develop your personal objectives and a system that fits those objectives. And you must work on your system until you are comfortable trading it. You must know your criteria for comfort. Most people have many biases against doing it well. To overcome those biases, most people need to take some steps in their personal development. I generally find that the more therapeutic work an individual has done, the easier it is for that individual to develop a system he can successfully trade.
One of your primary tasks is beginning the search for the right trading system is to find out enough about yourself that you can design a system that will work for you. But how do you do that? And once you find out enough about yourself, how do you find out what will work for you?
The third model I developed is on how great traders determine their position size throughout a trade. The topic of money management is talked about by every great trader. There have even been a few books on money management, but most of them talk about one or more of the results of money management (that is, controlling risk or getting optimal profits) rather than the topic itself Money management is essentially that part of your system that determines your position size – that answers the question “how much?” throughout the trade. I’ve chosen to call this topic “position sizing” throughout the remainder of this book to eliminate possible confusion that might arise. And since the first edition of this book, many of you have also adopted that term.
As is true in other areas of trading, most people are doomed to do all of the wrong things in terms of position sizing because of psychological biases that they have. For example, as I was writing the first edition of this books in 1997, I was on a speaking tour of eight Asian cities. In each city, it was clear that most of the audience did not understand the importance of position sizing. Most of them were institutional traders, and many of them didn’t even know how much money they could lose before they lost their jobs. Consequently, they had no way to adequately determine how big or small their positions should be.
To help my audiences understand this idea, I’ve had them play a game to illustrate the importance of position sizing. But when I finished talking, no one asked me, “Dr. Tharp, what should I do in terms of position sizing in my situation?” Yet almost all of them could make great strides in their trading by asking that question and getting an appropriate answer.
You’ll learn the key elements of position sizing in this book because it is an essential part of system development. However, the presentation of the entire model is another one of my books, The Definitive Guide to Expectancy and Position Sizing.
The fourth model I developed is on wealth. As I already mentioned in the beginning of this chapter, most people lose the money game because they follow someone else’s rules for how to win the game. They believe that the person with the most money or the most toys wins the game. Perhaps you win when you become a millionaire or a billionaire. But if that’s the case, most people lose.
Or perhaps you win if you have the most toys or the best toys. And if you play the game right, you can buy each toy now if the down payment and the monthly payments are low enough. Well, if you follow that rule, you’ll be led down the path of financial slavery as you acquire more and more consumer debt. Today, the average American is spending more than he or she makes for the first time since the Great Depression. And it is all done through borrowing. Thus, we’re clearly losing the money game.
My solution to this is to adopt new rules. Financial freedom occurs when your passive income (income that comes in when your money works for you) is greater than your monthly expenses. Thus, if you need $5,000 per month to live on, you become financially free when your passive income is greater than $5,000 per month. It’s that easy, and anyone with enough desire and commitment can do it. I’ve described the procedures in detail in my third book, Safe Strategies for Financial Freedom.
In this book, I want to focus more on trading as a method of developing passive income. If you can generate enough income through trading or investing to meet your monthly expenses, and if the process requires only a few hours of your time each day, then I’m willing to call that income “passive income.” And through this process you can be financially free. Although you may have to spend several years learning the business of trading and developing a business plan and systems that fit your plan, once that is complete, you could be financially free by my definition. I’ve seen many people do it, and if you have the commitment and the desire to work on yourself as the key ingredient in your success, then you can do it too.
I have divided this book into three primary parts: Part One is about self-discovery and moving yourself to a point where it’s possible for you to do market research. Chapter 2 is on judgmental heuristics , and Chapter 3 is on setting your personal objectives. I’ve deliberately made Part One a short section so that you won’ get too impatient with me for not giving you what you probably think is the “meat” of the topic of system development. The reason I’ve put this self-discovery material first is because it is critical to your success in developing your system.
Part Two deals with my model for system development. It covers concepts behind market systems, and I’ve invited various experts to write the sections behind those concepts. Part Two also deals with expectancy – one of those key ideas that everyone should understand. Few people who are actively involved in the markets even know what expectancy means. Even fewer people understand the implications of designing a system around expectancy. Thus, you may find it important to study this section carefully. I’ve also included a new chapter on understanding the big picture because that understanding is critical to developing your system.
Part Three covers the various parts of a system. These include setups, entry or timing techniques, stop-loss exits, profit-taking exits, and, one of the critical parts, position sizing.
Part Four is abut how to put it all-together. It includes a chapter on how seven different investors approach the markets. It also includes a chapter on how to evaluate your system, using some newsletters as examples, and a chapter on position sizing. The chapter that concludes this book includes everything else you need to think about to be a great trader.