Sunday, February 24, 2013

Van Tharp's thoughts on predictions and a low-risk approach to the markets

Dr Van K. Tharp is well known in trading circles, and has written several books on the trading psychology and risk control (position sizing) elements of trading. Indeed, I first became aware of him from his interview in Market Wizards. Similar to my own thoughts and other recent blog posts about the dangers of predicting future market movements, he had this to say in "Trade Your Way to Financial Freedom":

"People have an overriding desire to be right. Over and over again, I hear traders and investors tell me how important it is for them to be right when they make a market prediction or, even worse, when they invest in the market.

I once worked with a client who publishes a daily fax that gives predictions for a particular commodity. Big traders all over the world subscribe to his fax because his accuracy is outstanding. He's known worldwide for his accuracy. However despite the fact that his accuracy is outstanding, his ability to trade that commodity is rather poor. Why? Because of the need to be right. Once a person makes a prediction, the ego becomes involved in it, making it difficult to accept anything that happens in the process of trading that seems to differ from the prediction. Thus, it becomes very difficult to trade anything that you publicly predict in any way."

This follows closely on from Curtis Faith's idea that it is much easier to make money when you are wrong most of the time (refer to this post).

Trend followers in particular understand that a high accuracy or win rate is not a pre-requisite of making money in the markets. Trend followers simply react to price movements in the market - trying to predict what will happen is left to others. In most cases, trend followers have achieved consistent success being right less than 50% of the time. What is important is the overall expectancy of the system, and having the mindset to trade that system, allied to good risk control. You want to maximise the potential for gains while minimising the potential for big losses (i.e. letting profits run while cutting losses). In that sense, by knowing the historical performance of your system, allied to your ability to stick to the rules of the system, combined with the correct approach to position sizing, you can be wrong more than half the time in your trades, yet be able to approach the markets in a low risk fashion. Dr Tharp's definition of a low risk ideas is as follows:

"A methodology with a long-term positive expectancy and a reward (overall return) to risk (maximum peak-to-trough drawdown) ratio with which you can live. That methodology must be traded at a risk level (usually based upon percentage of equity) that will protect you from the worst possible conditions in the short run while still allowing you to achieve the long-term expectancy."

Trend following, as a concept, therefore fits the bill perfectly. A complete trend following system covers all these aspects - they are all integral to the system, and leave no room for human intervention (self-sabotage). From there it is a question on what you see (price action and its movement), following the entry and exit signals generated by your own system, while using appropriate risk control.

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